China is hard learning rather than hard landing

Recent turmoil from China has led to panic selling waves over the financial markets and most equity indexes around the world registered negative performance on Monday evening

The collapse of the Chinese stock markets since their historical highs in June, PBOC’s decision to move to a more flexible FX regime earlier in August, and the release of disappointing economic data have strengthened investors’ concerns of the global contagion of a possible Chinese economic hard landing.

Current economic situation in China is not a drama
Since the beginning of the year, Chinese economic indicators have been disappointing. Some signs of stabilization have recently emerged but economic activity cannot pick up materially in the current context and the Chinese economy will not sustain a 7% GDP growth over the coming 5 years. This is especially the consequence of the ongoing double structural rebalancing of the Chinese economy, driven by the government : rebalancing towards a domestic growth engine (consumption, in particular, instead of investment, for example housing) and rebalancing to a more service-oriented economy. Such transition is leading to slower growth ahead but, in the meantime, China will still need to grow fast enough to maintain social order, which represents a real balancing act for the Chinese government. However the consequences of a weakening Chinese economy will be largely felt in Asian trade partners and competitors (Taiwan, Korea, Japan, Malaysia), commodity exporters (Chile, Brazil, Middle East countries). Advanced countries will be affected, but the slowdown effect should remain modest.

In this context, the latest unexpected decision of the Public Bank of China (PBOC) to depreciate the Yuan should not be considered only as a way to support growth. In fact the CNY was practically the only emerging market currency to appreciate since mid-2011 when the strong USD trend began and, until now, the depreciation against the dollar is small (around 3%). Since then, “devaluation” has been partly misunderstood by investors, as it should be seen rather as a technical movement, changing the way or regime the daily fixing of the Yuan will be set towards a more market-based system. The ongoing reform and opening up of the financial system, but even more the IMF decision to delay the inclusion of the Yuan into the SDR (Special Drawing Rights) currency basket, have been the main reasons for the currency regime change. Unfortunately , the timing was a quite surprising, causing confusion for investors. Still, we believe that this depreciation will remain limited.

Nonetheless, China has proven to be very pragmatic and we are convinced it will continue to be have so. Thanks to the possibility of implementing monetary and fiscal stimulus, we believe that China will avoid a hard landing : all policy tools will be used to support activity, monetary policy will be eased slowly as the authorities want to keep control of the shadow banking system and finally, while local governments are largely indebted, the central government has, if needed, some room for manoeuvre. Besides, we also do not exclude the current slowdown adding to global deflationary pressures, especially in the short term.

Cautiousness is required for investment in emerging markets asset classes
Most Chinese equities in Hong-Kong reveal quality and attractive valuations but sentiment is still fragile

The A-share market “crash” was, in this environment especially, an accident waiting to happen as, even a year ago, these markets were already experiencing a real speculative (and government induced) rally, with inexperienced but highly leveraged retail investors jumping on this market bandwagon as an alternative to investment in the ailing property market. Nevertheless, the economic impact of the market correction will be relatively limited as stocks represent only 12% of the Chinese people’s financial wealth. Furthermore, at the end of July, only 15% of the population held equities in their portfolio. However, it could have some effect on consumer goods and increase banking NPL (Non Perfroming Loans) levels.

One of the victims of the A-share market collapse was the Hong Kong listed Chinese stocks – which were de-rated – as they also felt the impact of selling pressure, although in terms of valuations the so-called “H”-shares were much cheaper and, mostly, of much better quality. As those stocks have been strongly de-rated, valuations are becoming very attractive, with a lot of choice of cheap but quality companies in growing sectors with a visible earnings profile.

Current price levels should therefore provide an interesting entry point, but, as sentiment is still very fragile, caution is still warranted.

Emerging market equities : selective approach required
The same goes for the emerging markets equity asset class in general. Markets have been sanctioned in recent months, dragged down by uncertainties surrounding the global and China growth as well as local (Turkey, Brazil, etc.) and geo-political issues (Russia, Middle East, Greece, etc.). Speculation over the first interest rate “lift-off” by the Fed, pushing up the dollar, driving down commodity prices and increasing risk-aversion have also added to current head-winds for emerging markets in general.

The latest EM currency correction, due not least of all the Yuan depreciation, has poured oil onto the fire, with, as a result, one of the strongest corrections since the 2008 crisis in August. While a comparison with the 1998 crisis period, as some are mentioning, looks quite exaggerated as most emerging markets are fundamentally much stronger, the current global macro environment and uncertainties do not bode well for a strong buying proposal.

However as valuations are fast approaching crisis levels, indicating that a lot of the bad news has most probably been priced in by now, and with global growth (China included) starting to show at least some stabilization, and the global financial authorities’ stance to do “whatever it takes” to provide support to economies and markets (even at Fed’s level), we think that a consideration for a gradual accumulation of the emerging market asset class becomes valid. A selective or active approach will still nevertheless be warranted. As a consequence, we continue to search for “pockets of growth” through company selection, based on sustainable growth at a reasonable valuation and a thematic approach.

Emerging market debt: buying opportunities will appear when uncertainties regarding the timing of the first Fed hike and Chinese policymakers response to the risk of a hard landing subside

Emerging market debt, and especially emerging currencies experienced a significant correction. Sovereign spreads widened close to their September 2011 highs with the average emerging market sovereign yield well above 6.2%. Generally, commodity exporter credits and currencies were the worst hit, with Africa and Latin America underperforming and Asia, Europe and the Middle East outperforming in the hard currency sovereign asset class. Regarding the local currency environment, China trade and foreign exchange linkages coupled with the risk of further competitive devaluations drove a broad-based correction in Asia, as well as in commodity exporting countries in Latam and Europe.

Emerging market sovereign spreads are at multi-year highs and emerging markets currencies are reaching new record lows, suggesting that a good portion of the cyclical and structural risks are already priced in. Emerging market bond valuations are, thus, already attractive from a historical perspective.

But fundamentals are really mixed when different geographical regions are compared. The emerging market universe contains both commodity exporters (concentrated in Latam and Africa) and importers (concentrated in Eastern Europe) whose fundamentals are reacting differently to the risks of a China slowdown and the decrease in commodity prices. Political risks also differ: limited in Eastern Europe but elevated in countries facing elections like Turkey, Argentina and Venezuela and in others with ongoing corruption scandals like Brazil and Malaysia. The Fed hiking cycle has a differentiated impact on the universe, penalizing countries with high external imbalances, low foreign exchange reserve cushions and inadequate structural reform policies.

Globally, debt sustainability is not an issue for the overall emerging market sovereign universe as public –debt-to-GDP levels are still, on average, 40% (relative to the level of 90% in the developed markets) according to IMF data. Moreover, policymakers are also better prepared relative to other EM crisis episodes: foreign exchange is generally freely floating and central banks have rather stronger foreign exchange reserves; fiscal and monetary policy frameworks are, generally, more solid; and economic systems are more mature and less dependent on developed countries.

To sum up, although valuations suggest the correction should by now be largely exhausted, the uncertainties with respect to the timing of the first Fed hike and the Chinese policymaker response to the risk of a hard landing, will first have to subside. For the moment, we remain defensively positioned across local currency and hard currency strategies. Our investment strategies continues to focus on differentiation and favour exposure to attractive relative value opportunities.

Our cross-asset strategy: we maintain a preference for risky assets, especially equities in the Euro zone
Last week, while uncertainties about the health of the Chinese economy were increasing on the financial markets, we adopted a more cautious attitude, reducing our overweight in equities to become neutral. On Monday, we considered that reactions of the financial markets was too exaggerated and decided to increase again our exposure to equities while accentuating our overweight in Euro zone equities compared to US equities. As mentioned above, we are convinced that the Chinese government is capable of managing a soft landing and that the monetary support from the ECB and BOJ and the economic fundamentals in the Euro zone and the US will support equities, especially these in the Euro zone.

Euro zone equities should continue to benefit from firmer economic recovery as the direct impact of the Chinese slowdown should be limited. The low commodity prices will also be more supportive in Europe than in the US. We maintain a specific preference for peripheral equities (Italy and Spain) as we consider that their risk premia will decrease since Greece and the European Union have reached an agreement, and for small- and mid-caps, which have attractive valuations compared to large caps. Beyond that, we are underweight in US and UK equities, slightly overweight on Japan, while still neutral on Emerging markets.

Regarding bonds, we continue to favour more diversification outside government bonds and are keeping a below-benchmark duration. The moderate interest rate increase and the continuing monetary easing outside the US still continue to make higher yielding bonds interesting. In emerging debt, we have a preference for hard currency debt.

We are still defensive commodities as we think it is too early to invest in this asset class.

Koen Maes – Global Head of Asset Allocation Strategy and Funds – Candriam Investors Group