By Gary Greenberg, Head of Hermes Emerging Markets and Lead Portfolio Manager at Hermes Investment Management:
China: our short-term view
The Chinese markets have continued to fall today, but the offshore RMB rallied as the government intervened by withdrawing liquidity, causing short-term repo rates to spike. This, in turn, makes it very expensive to short the currency.
However, the stock market was left to its own devices, and duly gave up 5.3%. The problematic circuit breakers had been withdrawn, and any potential selling similar to previous interventions was put off to another day. Most interestingly, Premier Li Keqiang ruled out strong stimulus to boost demand. This supports the move to supply-side economics proposed by President Xi Jinping.
China: our longer-term perspective
Long term, most observers agree that fundamental reform – meaning increasing efficiency and productivity rather than mobilising yet more capital (mainly debt) – is essential for China’s long-term future. China’s growth model has to change, but the question is how to reverse the drivers of the economy: how can an economy in which investment is nearly 50% of GDP and consumption less than 40%, evolve to one in which consumption is over 60% of GDP and investment under 30%, in several years? This transition would be challenging for any leadership team. The jury is out as to whether the Chinese authorities will manage it without undergoing a major crisis.
This transition raises a tough challenge, but it is further complicated by the dominance of the domestic Chinese markets by retail investors with short time horizons and few fundamental tools with which to value stocks. These investors follow momentum, whether it be the momentum of economic policy, GDP growth, earnings, or share prices. Therefore, when the government hints at stimulus, regardless of whether or not stimulus will result in better long-term prospects for the country (and it is unlikely to, given its debt-to-GDP ratio is nearing 300%), retail investors plunge in. On the other hand, when reforms are put forward these investors sell, since reforms spell short-term pain as excess capacity is cut, companies make staff redundant and deleveraging occurs broadly.
In developed markets, and those emerging markets dominated by institutions (domestic or foreign), the dominant investor base is prepared, generally, to take short-term pain for long-term gain. In contrast, Chinese stock markets gyrate wildly at such a crossroad. Little has changed in the economic outlook for China in the past three months (it continues to slow gradually), but the mood has changed from euphoria to panic.
Is 2016 the year to build a position?
So, is it time to close your eyes and buy? Our view is that emerging markets have underperformed developed markets for the past five years because underlying companies have underperformed at the bottom line. Profitability has declined as global growth evaporated.
For emerging markets to outperform, profitability must first recover. This means profit margins need to rise, and for that to happen, wage hikes must continue to slow versus productivity improvements. This process is already underway but needs to become more evident. Second, the cycle must turn, as supply comes out not only of commodities but also basic goods like steel, aluminium, shipbuilding and other sectors. This process is just starting, and is unlikely to show meaningful results until next year.
We think it is fair to say that emerging markets are not yet discounting these positives. Unfortunately, they are not yet discounting all of the negatives either. At first glance, they appear very cheap. The emerging-market benchmark, at 1.2x, is now below the price-to-book valuation of 1.3x it reached in the financial crisis, and is approaching two standard deviations below its 10-year average of 1.9x. Two standard deviations would imply a further 10-15% drop. However, profitability in emerging markets is suffering, and thus the price-to-earnings ratio is less encouraging. Trading at 10.8x 2015 estimates, it is below the 10-year average of 11.7x but still less than one standard deviation below. And, looking at EV/EBITDA in order to consider the substantial increase in debt following 2008, emerging markets trade at 7.3x 2015 consensus expectations, in line with the 10-year average of 7.2x. A brighter outlook will probably require some combination of lower valuations, currency depreciation of 5%-10%, a change in the trend of US dollar strength, a bottoming of commodities markets, stabilisation of the RMB and local markets, and for corporate margins to improve. Our view, currently, is that the stabilisation of commodities and margins begins in 2016, becomes evident in 2017, and becomes a theme in 2018. Therefore, this year is the one in which to initiate a position in emerging markets, before building a strong overweight next year ahead of enjoying the ride in 2018.
Emerging markets: valuation in the context of debt is a key consideration
Periods of panic, such as now, are typically good times to look for stock ideas. While the valuation of the benchmark is not yet compelling on all measures, this type of market results in the mispricing of companies, which can provide real long-term opportunities.
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