Two elements in the current episode have been huge macro impediments for Emerging Market equities. First, the great bear market in China (MSCI China is over 20% of MSCI EM). Second, the US Dollar, rates, and liquidity. On the positive side, select markets in EM and Asia Pacific have performed well, most notably India and Taiwan. The historical gains experienced through prior Fed easing cycles have arguably played out.
We fear that the challenges from a synchronised US and China growth scare still lie ahead. To be fair, the structural growth challenges in China are widely appreciated. The tactical challenge is that cyclical conditions remain extremely disappointing. Tactical EM outperformance is also more likely if Harris wins in November. By Contrast, ASEAN would more likely outperform under the Donald. However, the greater forward-looking risk is China’s cyclical fragility and correlated risk on the left tail of the dollar smile (the dollar rising for the wrong reasons).
As we have noted for some time, China’s structural debt and growth challenges are widely appreciated. Earlier this year (5th of February) following a 3-year bear market and waterfall price action, equity valuation positioning and sentiment reached episodic or revulsion levels in China. While pessimism was warranted, there was widespread capitulation by domestic and global investors. The Shanghai Composite Index was trading at 4.7 times two year forward earnings.
However, as we also suggested at that time, the series of policy measures introduced by the authorities fell short of a “whatever-it-takes” moment. For example, the property stabilisation measures announced earlier this year represented only around 8-9% of total housing stock. Although we added to Chinese equity at the time, our sense was that the opportunity was only tactical. We reduced our exposure again (taking profit) in mid-July this year. What concerned us is that key indicators are not consistent with a turn around. The China credit impulse remains extremely weak in this cycle (consistent with weak M1 growth announced this weekend), Bloomberg’s China re-opening index (a basket of stocks levered to the cycle -chart 1) making new lows, real estate equities making new lows, correlated weakness in iron ore and other cyclical exposure (European luxury). The China 10-year government bond yield is also not consistent with cyclical expansion or a rise in China inflation expectations.
Chart 1
Looking forward, China might also face additional resistance to expanding global export market share. Especially if the next US Administration materially increases tariffs. As we noted above, ASEAN countries are more likely to benefit from a Trump administration. Given the “managed” exchange rate, the super-sized rate cut by the Federal Reserve last week was necessary to allow the PBOC to also cut rates further and ease liquidity. As we have suggested previously, elevated dollar rates are a constraint on China’s capacity to ease policy. Recall that the US dollar might still strength for the wrong reasons or the negative side of the US dollar smile (de-leveraging and risk aversion). Although broad imbalances within emerging markets are not as extreme as prior episodes, a large proportion of total debt is denominated in US dollars. That remains a challenge for EM.
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