During a recent media interview in Shanghai, a local journalist asked me why foreign investors were piling into the Chinese domestic market. It was a pertinent question. In the first eight weeks of the year, Chinese mainland equity markets saw a nearly US$17bn inflow through the “stock connect” corridor with Hong Kong — the largest consecutive inflow since the launch of the programme in November 2014.
Chinese domestic investors have been surprised by the strength of these inflows. In a market that is notoriously short term, they are probably as pessimistic about China’s near-term prospects as any western China-bear. Why would anyone be bullish on a market dogged by declining growth, corporate defaults and an impaired relationship with the US that threatens overseas prospects for Chinese companies?
The answer is simple: foreign investors do not look at China in a vacuum, as domestic investors do, but in relative terms. Also, many take a longer term view. The MSCI China A International Index, a proxy for the portion of the Chinese onshore equity market that is accessible to foreign investors, underperformed the MSCI World index by just over 30 per cent in 2018, reaching a price/earnings ratio of 10 times, close to its historical low. Arguably, it was discounting all the potential ills and no positive news ahead. Such an underperformance is a good cushion for international investors.
Some foreign investors see some light at the end of the tunnel, with the trade negotiations ongoing and a return to stimulus by the Chinese government, while others are positioning themselves for an increased inclusion of China’s mainland stocks in emerging market indices. Add to this that many global investors were underweight the world’s second-largest economy, and any prudent portfolio allocation would nudge towards some, just some, additional A share exposure.
China is not alone in seeing positive momentum. Exchange traded funds which buy emerging market equities have just had 18 consecutive weeks of inflows. The drivers are not dissimilar. In recent years, equity markets seem increasingly prone to taking extreme views: it is either Goldilocks or Armageddon. Whether this is due to the multiplying effects of passive flows or the rise of systematic strategies chasing the same factors, markets appear increasingly polarised. In the 11 months to November 2018, emerging market equities saw a 17 per cent underperformance against US equities, arguably discounting the Armageddon scenario and inching close to one standard deviation from the long-term average. Since then, investors have realised that emerging markets are not imploding after all.
Not that everything is perfect. Earnings growth is slowing and economic growth in China continues to weaken. Yet earnings growth for 2019 is still estimated to be positive (if anaemic, in the mid-single digits). What’s more, a good part of the negative revisions in recent months were due to direct and indirect consequences of the trade disputes, as companies have either been directly affected or have become more cautious with their spending plans.
While a deal between the US and China would not transform the earnings outlook, it would certainly eliminate a significant overhang. China’s economic growth will continue to weaken, but the government can still manage the soft landing with stimulus measures and more of these are likely later in the year.
At the same time, the threats that were hanging over emerging markets during 2018 are slowly being pulled back: the Fed has turned more dovish, the Chinese and US leaders are talking, and the Trump administration seems more willing to ink a deal. If all this also means a normalised dollar, as the US economy cools off and the Fed errs on the side of caution, this would be a power boost for emerging markets.
Yet in recent years, spells of positive emerging market sentiment have not lasted long. Will this time be different? The road ahead is likely to have some bumps. The US-China trade talks might hit a few rewind buttons, more Chinese companies could be banned from doing business in the US and other western countries, and there could be more threatening statements exchanged about Taiwan. There are other areas of geopolitical risk, too: elections in India with an uncertain outcome for Prime Minister Narendra Modi, and new administrations in Brazil and Mexico that are likely to hit some roadblocks.
Yet none of the above is as threatening to emerging-market earnings as an intensification of the trade war, and earnings are a key driver of emerging market stocks. This time will not be different — just a little less dramatic.
Fabiana Fedeli is global head of fundamental equities and portfolio manager emerging markets equities at Robeco
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