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…