‘Peak Pessimism’ on China and EM Suggests Q4 Rebound…

The narrative of slowing global growth, rising deflation pressures and monetary impotence to do much about it remains dominant in markets – that’s reflected in very bearish positioning among global asset allocators on most survey evidence and certainly conversations we’ve had. Back in our last blog post on the risks to emerging markets at end July, we concluded that: ‘While the modest recovery in Europe and Japan looks sustainable, a full blown EM crisis would be a global deflationary shock, particularly if associated with an RMB devaluation. The PBoC is now fighting deleveraging risks/propping up asset collateral values on so many fronts, from the ever growing local government debt swap to the attempt to stabilise collapsing A-shares, that something will have to give…’

Our view since last year was that the RMB’s real effective appreciation against EM peers was unsustainable and likely to reverse with a target of 6.8 versus the USD by end 2016. The ‘shock’ RMB depreciation move in August deepened anxiety about the scale of China’s slowdown and the credibility of policy makers to deal with it. The poorly managed and communicated FX shift, like the preceding stock market intervention, indicates that Beijing’s clever and largely US educated technocrats face a steep learning curve in managing capital market expectations.

The subsequent collapse in commodity and resource stock prices looks more reflective of a 20% RMB fall versus the dollar rather than a 2% one. After the worst quarter in several years across global markets from high yield US debt to Japanese equities, will a degree of stability in China boost risk appetite in Q4? Recent measures to restrict capital outflows have seen the CNH/CNY rates converge and volatility subside, while the margin debt deleveraging process for A-shares now looks complete. The slowdown in China led by investment/heavy industrial activity has long looked inevitable and is ultimately healthy; the services sector is likely being systematically underestimated (possibly by upward of $1trn) given the Soviet style ‘count the bricks’ GDP methodology – whatever you believe ‘true’ GDP growth to have been this summer, with a fast improving property market and recent stimulus measures, momentum should be soon improving from that cyclical nadir.

From a  tactical perspective at least, we’re likely approaching ‘peak pessimism’ for both EM and commodities – negative sentiment and flows for both have been driven by deepening China fears. Even slightly better China data through year-end after the concerted fiscal and monetary stimulus of recent months would lead to stabilizing commodity prices and hence EM currencies; that would trigger a resumption of carry trade inflows as well as equity fund net flows turning positive. Turkey and Brazil remain high risk given political uncertainty, high bank sector loan to deposit ratios and weak net international investment positions (-50% of GDP in Turkey’s case). Real rates in Brazil are already touching 5% and further rate hikes to support the real would push the economy into an even deeper recession next year and drive a surge in corporate defaults.

However, EM Asia looks attractive after the summer selloff; the MSCI AXJ is now on just 11x forward earnings, and while net earnings revisions remain net negative, the pace of downgrades is abating – HK listed H-shares, Taiwan and Korea look likely to outperform if broader sentiment rebounds and unusually high levels of institutional cash are deployed. So does Japan, which despite the softening economy raising deflation risks remains attractive on the multi-year bottom up corporate governance/payout ratio theme. The odds on further BOJ intervention are rising, likely focused on equity ETF and REIT buying given liquidity issues in the JGB market. Overall, improved cyclical macro news flow from China remains key to a rally across global markets into year end and should be imminent, even if the huge structural challenge of deleveraging and rationalizing the SOE sector remains…

Japanese Equities Break Out, Despite No Structural Reform ‘Third Arrow’ Yet

20th November 2013

The tactical asset allocation stance since Q3 has been long USD and Japanese equities for a breakout to the 17-18k level on the Nikkei by end Q1 and a move toward my productivity adjusted 110 target on the JPY. While I’ve been on the road in Asia, those bets have been paying off, while China has surprised the skeptics by announcing a broadly coherent if as ever gradualist set of pro-market reforms to reduce some of the most glaring economic perverse incentives which have undermined productivity growth and the capital-output ratio. Japanese equities trade on a 14.5x forward PER with scope for a pick-up in ROE as well as renewed JPY weakness, but above all the much heralded domestic asset reallocation into inflation hedges. Not to mention real estate; I noted on my travels prominent ads in papers from HK to Singapore and even Bangkok for prime Tokyo condo developments, which would have been unthinkable a year ago but which the yen move and ultra-low JGB rates have turned into a compelling arbitrage versus overheated (and increasingly tightly regulated) local markets. But could domestic household formation also begin to drive real estate demand?

I got talking at an airport lounge to a very senior Japanese banker who is convinced that the Abe government will soon allow joint bank accounts, joint mortgages, and joint title to property for married couples, who for the first time would be treated as a single unit for tax purposes, all of which would boost the female workforce participation rate and potential growth. That wouldn’t be so much a ‘third arrow’ as an economic Scud missile, because the anachronistic social contract for educated women in Japan has been driving many adverse trends from a low marriage and fertility rate to the moribund real estate market. A surge in dual income, reproducing and mortgage borrowing households is one key to boosting real growth to anything like the 2% a year through 2020 forecast by the government, when underlying potential growth is estimated by the BOJ at only about 50bps.

Japan trades on a P/B of 1.3x but trailing ROE is only 7% – just a little over half the return from global equities as a whole. There has been some modest improvement in in the last few quarters, in part as the weaker yen has helped boost EPS. The consensus currently expects substantial improvement to about 9.5% over the next year. Japanese ROE is so far below other markets in part due to lower asset turn but above all because of lower margins. Structural reforms that work to improve the level of net income margins remain key to a sustained rerating of Japanese equities.

Political Populism Means Thailand Continues to Underachieve…

9th October 2013

Thailand is probably the most disappointing emerging economy in Asia and possibly across GEM, in terms of economic and political progress over the past decade. While unemployment is practically non-existent, productivity has stagnated. Graduates from local universities are generally only fit for (and satisfied with) low skill call centre/retail work, while factories face a labour shortage as farm workers enjoying the subsidy bonanza stay in the rice paddies. Infrastructure investment has been a paltry 1.5% of GDP and trend GDP growth has stalled at around 4% over the past decade, while private sector credit to GDP has risen to 150%, after a consumer lending boom. Overall, the country’s competitiveness has been slipping versus regional peers; in the World Economic Forum’s latest competitiveness rankings, Thailand ranks 74st globally in health and primary education provision and 85th in the quality of its institutions, 50 places lower than Malaysia and significantly weaker even than Indonesia. The seven year build out of infrastructure to integrate the wider sub-region around Thailand as a logistics and finance hub will be critical to boosting the medium-term growth trend toward 5%.

The long-term challenges facing Thailand include a fast ageing population, out-dated infrastructure/ industrial plant and a weak education system at all levels. To boost trend growth to mid-single digits, Thailand will have to bring significantly more workers into the formal economy, boost productivity enhancing investment and reduce glaring income inequalities that have undermined political cohesion. For investors, a sustained period of political stability is important in tackling these structural issues, although the current subsidy program to boost rural incomes, while reducing extreme income inequality, is having unintended consequences.

Indeed, the central bank governor warned recently that the populist subsidies “add to micro-level risks by making households addicted to ‘easy’ money, while also adding to macro-level risks by stretching fiscal resources without enhancing competitiveness in any meaningful way.” Corn famers for instance have been protesting to force the government to extend the current subsidy program due to end in December for another four months. The country has seen a range of other special interest groups from rubber to corn farmers demand hand-outs of their own. The subsidies are adding to rising public spending, led by the 700bn baht, or $22bn to support rice farmers since the 2011 election. Thailand’s rice subsidies, which bought up rice from farmers at double the market price, also have knocked the country from its position as the world’s largest exporter of the grain as huge domestic inventories build, as cheaper rice from India and Vietnam took market share.

Thailand’s finance ministry recently cut its growth forecast for this year to 3.7% from 4.5%, which still looks a bit high – growth should rebound to 4.5% next year if the delayed infrastructure program begins to be implemented. Exports account for around 60% of GDP but Thailand is trapped in low end assembly operations, without the education system or infrastructure to move up the value chain. At the same time, the government’s goal of raising living standards and consumer spending in rural areas appears to be having unintended consequences. Some farmers are using the promise of guaranteed future incomes as a basis for borrowing more money. High prices guaranteed by the government are encouraging over-investment in farming.

Tax revenues are only 18% of GDP, and a proposed corporate tax cut to compensate for higher mandated wage costs will be hard to offset elsewhere. By law, public debt must not exceed 60% of gross domestic product, from 44% currently, but is forecast by the IMF to rise to 52% by 2018. On a net debt basis and excluding the liabilities of majority government-owned state-enterprises current debt is around 21% of GDP. While those debt levels look modest, private debt is the key concern, and the public debt picture is clouded by Thailand’s population ageing faster than any other in Southeast Asia apart from Singapore, with the proportion of the population over 60 in Thailand will reach 20% by 2025 with minimal pension provision, as mortality and fertility decrease steadily. Only South Korea and China face a similar demographic challenge in the wider Asian region while net foreign investment has been trending downwards, helping to exacerbate an overall shortfall in investment, which has run at under 30% of GDP in recent years.

The 2011 election campaign focused on tackling income inequality, which has become a key regional theme. Income inequality in Thailand is more extreme than in other regional emerging economies such as Indonesia, Malaysia and the Philippines, with the wealthiest 20% of Thais earning over 14 times more than the poorest 20%, compared to 9-11 times elsewhere in the region and 5-8 times in Europe and the US. The Puea Thai party offered to guarantee a uniform daily minimum wage of 300 baht ($10) throughout the country, rising to 1,000 baht by 2020, universal medical care for under a dollar a visit, a $500 monthly starting salary for graduates and a debt moratorium focused on low earning civil servants and farmers although the most expensive promise was the rice subsidy.

Despite the robust real growth in manufacturing since 2000 (an average of over 6% annually) the share of the workforce employed in factories has stayed at about 14%, with another 3% employed in export related logistics. Increased automation and worker productivity supported higher output, but did not contribute to integrating more Thai workers into the higher value-added export sectors.   The weak employment performance of manufacturing has fed the core political problem of growing wealth concentration (one which China also now faces). The country’s income inequality is the result of many divisions including the oft cited urban-rural divide, but also one between Bangkok and the rest of the country. Less than 20% of the Thai population lives in Bangkok and along the Eastern coastal region but generate over 70% of the country’s GDP and consume the bulk of public resources such as education and healthcare. This deep rooted inequality will continue to be a source of recurrent political instability in the months and years ahead, particularly if economic growth continues to lose momentum…

Emerging Markets Get a Wake Up Call From the Fed…

Just as the PBoC shocked markets last month (and perhaps itself) by engineering a record spike in interbank rates to instill some lending discipline, the RBI last week reversed course on easier policy as the INR broke the 60 level versus the USD, amid an ominous rally in oil prices. Growing concerns about bank asset quality and a looming surge in loan write-offs set against the backdrop of a structural economic slowdown is a narrative as relevant to India as China right now, although the key difference is in the huge divergence in their currency performance and capital flows. In real effective terms (i.e. trade weighted and relative inflation rate adjusted), the RMB has outperformed the INR by about 25% since early 2010, and the impact of FX moves as much as funding costs on sector selection has been critical in both countries (with an ongoing profit windfall for Indian exporters).  Indian bank NPLs reached 3.5% per at the end of the last financial year, with “restructured” assets now accounting for maybe 6% of loans. According to Fitch, the combination of bad and restructured debts will reach just under 12% of loans, or 3.5trn Rupees ($60bn), by next April, a level that has nearly doubled in just two years.

Short of reversing course and following Indonesia in raising the repo rate to stem the currency slide, this was a very aggressive attempt to draw a line at around 60 INR to the USD. The repo rate has been cut three times this year and was held steady at the RBI’s last monetary policy meeting in June. Given the risks of further global portfolio flow volatility, the rate cut cycle is almost certainly over for this year at least. In a statement published last week, the RBI said: ‘The market perception of likely tapering has triggered outflows of portfolio investment, particularly from the debt segment. Countries with large current account deficits, such as India, have been particularly affected despite their relatively promising economic fundamentals.’ India’s current account deficit was 4.8% of GDP at the end of the fiscal year to March, or $88bn, up from $78bn a year earlier.

Since the Fed suggested its Q4 exit strategy, foreign institutional outflows from the equity market have reached almost $3bn (although still up a net $12bn YTD) and from debt markets over $5bn, while the rupee has depreciated by about 10%. As in Indonesia, the 10-year yield has broken 8% and interest rate sensitive equities from real estate to banks have been hit hard. The proposed liberalization of FDI limits in important infrastructure sectors such as telecoms is a minor positive against this backdrop, and we are going to see a surge in government expenditure pre-election (spending is set to rise 16% y/y in the current FY to end March 2014, versus 9.7% in the last) but the situation remains dangerous until the currency/current account stabilize.

The RBI raised its Marginal Standing Facility interest rate (the cost of borrowing from the RBI using its emergency liquidity mechanism) by two percentage points to 10.25%, bringing it to 300 bps above the repo, its main policy rate. The RBI’s Bank Rate – the standard rate at which it lends to Indian banks was also raised from 8.25% to 10.25%. Funds available under the RBI’s liquidity adjustment facility – which helps banks adjust daily mismatches in liquidity at a softer rate of 7.25% – have been limited to about 750bn rupees ($12.6bn). On the other side of the world, India has had a glimpse of what a reformist, ambitious government can do.

Mexico, which is already the biggest beneficiary of China’s deteriorating manufacturing competitiveness as reflected in US export market share and has been tackling rampant corruption (for instance, in the notorious teacher’s union), unveiled an investment plan to upgrade the country’s key infrastructure, which including investments from the private sector, could hit 4trn pesos ($314bn) between now and 2018 or almost a third of Mexico’s annual GDP. As I’ve long highlighted, the ‘rising tide lifting all boats’ macro scenario for GEM via the positive terms of trade boost from China via commodity prices and the resultant capital inflows is over, the quality of governance matters more than ever for investors, as evidenced by the execution of structural and institutional reforms to boost productivity and domestic demand. Mexico and China are voluntarily starting down that road, Indonesia and India are being forced to by markets, but with questionable technocratic competence to deliver while Russia and Brazil look hopelessly behind the curve. This is all an overdue wake-up call for complacent emerging market policy makers and indeed investors in the asset class.