PAUL KRAKE - Can EM rally without Chinese stocks?


Can EM rally without Chinese stocks?

(This is an excerpt of our Sunday blotter. We have edited a part out.)

In hindsight, I understand why many of my regular readers were blindsided by a report on Friday that announced that the thematic model portfolio was halving its position in Chinese equities. Inadvertently, it was published on a Friday when US payrolls are released which is normally a busy data day for most of you, but it was never my intention to slide it in under the radar. The timing of a series of sobering Expert Series calls on trade, debt sustainability of Belt and Road and the current implosion of Chinas peer to peer (P2P) lending market was enough to tip the scales. While I do not believe that China is heading to a crisis and in fact, I remain convinced that Chinese growth will re-accelerate going forward, I feel there are much better ways to play a rebound in emerging markets, both tactically and on a two to three-year view.

For those of you who didnt read my report The Demise of Belt and Road (September 7th), here is the summary:


This is not a reduction in risk. In fact, global miners are higher beta than index exposures in the Shanghai composite, but this is offset at the margin by a conservative allocation to the fixed income securities of European financials. Global miners are cheap with free cash flow yields relative to the broader market at levels not seen since 2008. The likes of BHP and RIO are sending billions of dollars back to shareholders in the guise of buybacks and special dividends and should benefit as Chinese and European growth rebounds from H1 sluggishness.

I feel that European banking fears about Turkey with worries about UniCredit, ABN, Santander, and BBVA being considerably overblown. With Turkey being less than 1% of their loan books, concerns about balance sheet destruction are not realistic. The Italian budget debates over the next six weeks will be a cause for concern, but it is difficult for me to see NPLs rising while the ECB has cash rates that remain negative. While this weeks ECB meeting may provide further guidance for the end of QE and beyond, financial conditions remain incredibly loose. Current talk about a slight widening of the budget deficit is probably not enough to see Italian spreads widen or the Euro slide.

The key question I am receiving from clients is whether or not Emerging Markets can rebound without the participation of Chinese equities. Several points:

  • You must make the distinction between Chinese stocks and Chinese growth. Chinese economic activity is what matters to other EM economies and the three-pronged stimulus that we are currently witnessing, targeted fiscal, monetary and a trade weighted softening of the RMB, should ensure a growth rebound later in the year.
  • Sentiment towards Chinese equities is being weighed down on US/China trade fears and by weakness in the P2P market that has seen a wave of closures and investor losses by smaller platforms. The numbers are meaningful and while not systemic, its enough to keep Chinese retail investors on the sidelines. As for trade, it is becoming increasingly clear that President Trump plans tariffs on the vast majority of Chinese imports into the United States and this is going to hurt not just China but global sentiment. That said, the economic impact should be compensated by fiscal pump priming. Markets suffer, the economy less so in the near term.
  • Tactically, we are seeing some chinks in the armor for US equities after months of stellar performance. Is it September seasonality, tech regulation fears, or the realization that the business-friendly agenda of the Trump administration is under threat with Novembers mid-term election likely to swing the balance of power to left leaning Democrats? Is it the absence of good corporate news? Is it Italian budgets or Brexit disruption? Is it Turkey, Argentina or Elon Musk smoking weed? Pick one or all but sentiment has turned, and risk is being reduced. It is interesting to note that EM currencies rallied last week when US tech stocks had their worst week in five months. Rotation? Thats a stretch but it is clear that shorts were being covered.

The upcoming week is filled with data and events. Turkeys central bank meeting is the key. After nasty inflation releases, they need to raise rates again and any refusal will be seen as a political directive from President Erdogan. The Lira would plummet. US CPI this Thursday should come in a little softer. Anything but would push yields higher after strong average hourly earnings on Friday. Swedens election this Sunday will reinforce the populist narrative in Europe. More tariff noise as US / Canada trade negotiations continue and expect more negative sentiment as President Trump sets his eyes on Japan. Ironically, this is likely to be a yen strengthening narrative. Finally, your inboxes will be littered with look-backs at the demise of Lehman Brothers as the 10th anniversary arrives. Lots of commentary about what has changed and what hasnt.

The ECB and BOE will meet this week. On Monday, Japanese GDP, Chinese CPI and PPI, and the UK releases Industrial and Manufacturing Production. Tuesday UK Employment. Wednesday, Indian Industrial Production and Exports. Thursday, Japanese Machine Orders and PPI, German and US CPI. Friday, Japanese and US Industrial Production.


The View