09 Apr 2024
The stock market in China entered 2024 under pressure, with poor economic data and concerns over weakness in the property market. Property has been a key driver of growth in China and is also important for its wealth effect with around 80% of individuals' savings invested in property. 2023 saw wages in China under pressure with both the private sector and public sector workers in some cases seeing actual declines in nominal pay. In this environment it was no surprise to see consumer spending under pressure and it was stocks in the property sector and consumer facing names that saw some of the largest price declines last year.
After seeming indifferent to the moves in the stock market for much of 2023, authorities now seem to have realised its potential impact on the wider economy and have attempted to support market levels, both by encouraging state intervention-led buying of China stocks, and more pro-friendly market noises. Recently, President Xi welcomed many top-level US chief executives to China in a bid to persuade them the country was still a good destination for inward investment. Xi seems to have woken up to the fact that the economy is struggling with a deep property slump undermining domestic demand and causing economic uncertainty, resulting in an already high savings rate going even higher with consumers lacking confidence to spend. Fears of mercantilist trade policies by China have raised concerns and there are potential threats of tariffs from trading partners. With rising geopolitical tensions, foreign direct investment fell to its lowest level since the 1990s last year. In response to this Xi, since the middle of 2023, has sought to stabilise the US relationship, meeting President Biden in San Francisco in November and China has continued dialogue with the United States.
Xi seems to have recognised that China needed to move to higher quality growth rather than relying on debt-fuelled investment in real estate and with the significant infrastructure build out in the country over the last 20 years, a reliance on fixed asset investment to drive growth could not continue without incurring wasteful spending. The government in China is committed to providing housing for lower income earners and the elderly, but Xi has often stated housing is for living in rather than speculation. China wants to focus on ‘new excellence’ in high end manufacturing, increased consumption, and expansion of export markets, especially in key industries such as electric vehicles, and solar.
After January falls, both China and Hong Kong markets have seen a bounce, with China entering bull market territory, rallying by over 20%. Markets have been supported not just by state inspired market intervention, but the belief that China will not see an economic collapse with the reiteration of its 5% growth target for this year. In China and Hong Kong, companies reporting has not met analyst expectations, undershooting by around 3% in Hong Kong and 5% in China. The biggest earnings misses have been amongst property developers, utilities, and healthcare companies. On a more positive front, China’s factory activity in March hit a one year high with the PMI rebounding to 50.8, crossing into expansionary territory after five months of contraction. Other more recent economic data has also been more positive including retail sales and fixed asset investment and it seems likely China will hit a growth rate of 5% in the first quarter. The most recent China Beige Book painted a more optimistic note on economic activity including jobs and retail sales. Stimulus packages rolled out in October may be relatively small by historical standards but do appear to have stabilised the economy, although the property sector continues to be a drag with property investment down close to 10% year on year. For the remainder of this year, a stabilisation in the property sector and continued rebound in the stock market would help consumer sentiment, as there has been a negative wealth effect for several years. Another positive for China is valuation and at one stage, stocks such as Tencent had fallen to a PE of 10x and JD.com to 7x. The latter has issued market beating results and seen the share price rally significantly from its January lows.
Overall, the economy in China is weak but the government does seem more aware of the importance of improving confidence within the private sector which has been the engine of job creation in the post GFC period. For the savings rate to fall significantly, the social security welfare safety net will need to be built out and the granting of residency rights for migrant workers in cities (the much-discussed Hukou reform) would be significant positives. It remains in the interests of the Communist Party for the economy not to collapse as it has based its legitimacy on delivering rising living standards despite a lack of political freedoms. There are continued risks in China equities if the economy continues to stabilise and sees a recovery in growth in the second half of the year but there is potential for the market rally to continue as valuations remain low.
Fund managers visiting India and comparing it to the pre-pandemic period report a visibly more dynamic and buoyant economy. The economy had been subdued in the run up to the pandemic as the country was coming off the period of demonetisation, there was the introduction of the nationwide GST in 2017 and a non-banking financial crisis the following year. Today, with the nationwide GST seven years old, tax collection in the country has improved significantly, as has the ease of doing cross state business within the country. The economic reforms put in place are now delivering on what they promised, and another notable achievement has been the nationwide biometric social security system which has reduced fraud and ensured payments go to those they were intended for. These improvements will continue to impact positively over the next decade on both companies and the wider economy.
The build out of the mobile telecommunications network in the country led by Reliance Jio has aided financial inclusion and India has used technology successfully to modernise its economy. On the ground in India roads, airports and metro stations are much improved as the build out of infrastructure continues. The availability of electricity will benefit not only productivity but the education of the young and overall, the mood in the country is very positive.
As a result of these structural growth improvements, corporate earnings growth should be much stronger over the past decade than the previous one and the long growth runway part explains the higher valuation of the market versus the rest of Asia. Within Emerging Markets, India is viewed as a natural home for investors seeking high quality companies and a deep stock market allows significant investor choice. India has also benefitted from being a long-standing functioning democracy with an independent judiciary and the country has a federal structure giving much power to individual states, so despite the dominance of one political party, will not go the way of China. The continued under penetration of what in the developed world are considered basic consumer goods, is an example of the long growth pathway and opportunity for many businesses. In India, penetration of even toothpaste is low and many western multinationals have listed Indian subsidiaries such as Colgate-Palmolive India and these subsidiaries not only have a higher growth rate than their parents, but also offer investors higher levels of corporate governance than is prevalent in some emerging market economies.
India continues to have positive demographics, and in fact is still struggling to provide quality jobs for younger members of the population, which the Modi administration is seeking to address through the build-up of manufacturing in the country and over time India should continue to benefit from the plans of multinationals to reduce supply chain dependency in China. The market rarely looks cheap but the long-term growth potential of the Indian consumer and under penetration story should allow well run businesses to successfully compound high c.a.g.r. rates over many years and the economy in India is now a tailwind rather than a headwind.
Latin America, traditionally an area troubled by inflation, saw a swift response by most of the region’s central banks when inflation soared in the immediate aftermath of the coronavirus pandemic which has transformed their credibility. Brazil and Mexico raised rates in the first half of 2021, while Chile, Columbia and Peru followed later that year. In contrast, banks in the major western economies delayed until 2022. In Latin America, central banks have now looked to follow the example of developed world central banks by acting independently of politicians and introducing inflation targeting, together with flexible rather than rigid exchange rates. Bankers were also aware of the history of hyper-inflation in the region which made them more attuned to the risks of delaying rate rises. Rates reached far higher levels than in advanced economies at both the nominal and real level allowing rate cuts as inflation has eased and growth slowed.
Central banks in the region remain aware of the risks of cutting rates too fast, but in Brazil, rates have declined to 10.75% from 13.75% even though the central bank remain aware that underlying inflation remains above target. Mexico is the second largest economy in LatAm and has been relatively resistant, benefitting from its proximity to the United States with growth of 3.3% in 2023 and unemployment at historic lows. Service inflation has remained higher than expected, although is well below its peak and the Bank of Mexico recently cut rates by 25bp to 11%, although cautioning the market should not necessarily expect a further rate cut in May. The central bank does not want policy in Mexico to turn too restrictive but left the prospect of more rate cuts before year end on the table. Rates have also fallen in other Latin American countries such as Columbia and Chile.
Brazil has many well-run private sector businesses, but a feature of the second term of President Lula Da Silva was government interference in some of the biggest companies and this month state controlled oil company Petrobras, which has world class assets, saw the stock fall 10% in a single day after it opted not to pay extraordinary dividends, a decision driven by Lula and his Ministers. There is also concern about interference in the board of mining company Vale and an increase in state activism would be a negative for businesses that are vulnerable to government interference. On the more positive side, domestic economic fundamentals saw a growth of nearly 3% last year and a have a strong trade balance and Petrobras shares are still up around 60% since Lula started his third term. The government in Brazil wants Petrobras to reduce shareholder payouts in favour of greater investment in areas such as renewables and refineries to stimulate economic activity.
External factors can be important for emerging markets, although Xi has sought to improve China/US relations, but the election remains a wild card. With China grappling with a domestic economic slowdown, now is not the time for China to up the ante on Taiwan and attempting to avoid conflict seems likely. The US election remains important for the entire emerging world with Trump, if elected, promising to impose additional tariffs on all imported goods into the US and the threat of specific China targeted policies. American businesses, as demonstrated by the recent visit of top CEOs to the country, remain keen to do business in China and continue to pitch for inward investment by US corporations.
There are risks when assessing the outlook for the emerging market region, but generally favourable valuations remain and for many countries an improving or positive fundamental economic background. In the past, US$ strength has been a headwind, but emerging market central banks, by acting earlier in raising rates, have positioned their domestic economies relatively strongly. The US remains likely to enter a rate cutting cycle in 2023, even if this is delayed until the second half of the year. In terms of long-term macro tailwinds, India stands out, though is more expensively valued than other markets in Asia. Mexico continues to benefit from its close trading links and proximity to the United States.
Emerging markets over the medium term should benefit from their attractive demographics (excluding China) together with an abundance of labour and skilled workers, a factor especially true of India. Some countries will benefit from multinationals pursuing a China Plus One policy in terms of how they achieve manufacturing diversification. Valuations in emerging markets by historic standards look attractive and if the economy in China continues to stabilise and shows recovery in the second half of the year, the region offers potential for further gains.
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