Tuesday, September 8th, 2015

Crowding Out

Here is some good news about Emerging Market equities, but it’s only relative, and nobody is going to break out the champagne as a result. The good news is that relative to Developed Market equities, the risk/reward ratio for EM has stopped getting worse and has even improved a little since the middle of August. The bad news is that against US Treasuries they have reached a maximum underweight recommendation, and our model suggests that it normally takes between 12 and 18 months to get out of this space once they have fallen into it. Another way of summarising this information would be to say that what started as an emerging markets crisis has begun to affect developed markets and that there is little prospect of a self-started recovery.

This is normally the cue for a discussion about whether it is possible for the authorities in China to maintain a GDP growth rate of 7%. We are surprised and slightly apprehensive that so many economists have rushed to reiterate forecasts when it is glaringly obvious that something important has changed. There isn’t enough new good-quality information available to say whether the 7% trend is – or is not – sustainable going forward. This means that investors are now trying to price the risk that that it will not be maintained and this has led to a much wider range of forecasts. In normal circumstances they would take something close to the worst case scenario, wait until it was reflected in share prices and then start to buy, even if they had to wait for another 18 months.

However we don’t think that China failing to grow at 7% is the worst thing that could happen to emerging markets. The real risk is that they end up being ignored. China appears to have decided that it will support its equity market at about 3000 on the Shanghai Composite Index. Our opinion as western investors is irrelevant. The decision has been made and we think it’s quite likely to succeed. There are parallels in Asia for this sort of direct intervention by governments. The most recent example was the Hong Kong Monetary Authority buying the Hang Seng index in 1998, when various hedge funds tried to force it to break the peg with the US dollar. The Japanese also successfully intervened between 1964 and 1966 (which is why the failure of this policy in 1989 was such a shock to them). The key ingredients for success are (1) a large quantity of foreign reserves (2) unwavering official determination and (3) a medium-term exit strategy.

For China the exit strategy revolves around its full admission to the MSCI world index and similar indices. The failure to achieve this was one of the events which started the correction in July. There is still no fixed timetable, but a reasonable estimate would be sometime in 2017. Unfortunately this may be the same timeline as that suggested by our model for the recovery for EM equities relative to US Treasuries. By this time the Chinese equity index may well be capitalised at more than the combined total of all the other emerging markets. At the very least it would require its own separate allocation in equity portfolios. This means that the traditional EM equities will face a totally new sort of competition. Investors may decide that it is simpler to invest in one large country rather than a series of smaller ones, whose growth rates are essentially a derivative of Chinese GDP. The fact that the authorities have successfully supported the local equity market may well be regarded as a positive.

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