Equity Monthly: Green shoots, or not, and the Chinese dream

While our overall stance is defensive there are still opportunities in this part of the business cycle, both in relative and absolute terms. In our monthly equity presentation from February 26 we highlight three markets (South Korea, Australia and Hong Kong) and five industries (Retailing, Pharmaceuticals, Software & Services, Telecommunication and Media) as segments of the equity market that tend to do well when the economy is operating below its recent trend and is still slowing (current phase of the business cycle). 

The single stock names highlighted below are objectively selected based on being in the top five on market capitalisation. In essence treat these stocks as indications of names to find in these equity segments and not as investment recommendations.

Looking at global equities from a helicopter perspective, valuation is still not an issue. As of February, global equities are valued just above their average valuation level since 1995. Investors should worry less about valuation and worry more about the trajectory of monetary policy and macro. 

While we have talked a great deal about macro in the past couple of Equity Monthly updates, as well as in our regular daily commentary, monetary policy is also shifting gear. The European Central Bank has delayed policy normalisation and is now contemplating (T)LTRO as a means to provide credit to the system. The Fed has made a historic U-turn and vice chairman Richard Clarida recently said that yield cap as an instrument is on the table. We are going deeper into the rabbit hole in terms of monetary policy. On the margin here it is likely positive for equities but in the longer term the outcome is more uncertain.

The Chinese equity dream

In many ways China wants what the US has. A global reserve currency, strong financial  markets, a large military, the biggest economy in the world etc. China has come a long way in the past couple of decades and is now a real challenge to the US. 

Even on a conceptual level, China is copying the US narrative and historic path. Xi Jinping talks about the Chinese dream and for that to succeed, the country needs broad inclusion in the upswing. In the last century the US managed that through spreading the gospel of equity ownership and by preaching the wonders of the equity market. Now China is likely to pursue the same route. 

The government knows that leverage in society is high and linked to housing. Using the equity market, the government will likely try to contain leverage in the housing sector and instead direct resources and support towards the equity market. If the Chinese population adopts equity ownership of corporate China then wealth will spread like a butterfly to all corners of the Chinese society. The Chinese government also announced in November 2018 that the Shanghai Stock Exchange is approved for their version of ChiNext (a NASDAQ-style board for Chinese technology on the Shenzhen Stock Exchange). We expect measures and support for Chinese equities will continue to rise in importance for China’s government as a vehicle to continue growing the economy.

Assisting the Chinese efforts to create the Chinese equity dream, MSCI announced yesterday that Chinese A-shares will see their inclusion factor in the MSCI Emerging Markets Index rise from currently 5% to 20% in three stages (May/Aug/Nov 2019) each raising it by 5%-points. 

This is a big news that means that China is clearly pursuing open market reforms faster than initially calculated for by global investors. Deeper integration in global financial markets obviously reconfigures the global financial system, which creates new and deeper feedback loops in the financial system. From China’s perspective this is the necessary road to eventually a floating currency which is the end destination if China truly wants to become the leading country in the world.

The bigger question is now whether the rising inclusion factor in the MSCI Emerging Markets Index leads to a rally in Chinese equities. It’s almost impossible to answer this question as price setting is a function of buyers and sellers. Foreigners own 2% of the total market capitalisation and 6.7% of the free-float market capitalisation according to the People’s Bank of China. 

The share of foreign ownership will now rise and if not driven by active investors, then surely by passive ETFs. But this inflow is in itself not enough to raise equity valuation or prices because there are sellers (likely domestic Chinese people) on the other side and depending on their liquidity needs it may not lead to anything. 

Equity markets rise long-term due to rising corporate earnings. Everything else is just mean reverting noise. The Bloomberg opinion piece by Shuli Ren and Rachel Rosenthal about Chinese equities and the MSCI inclusion points correctly to the fact that rising foreign ownership is not always salvation, just look at Argentina and Indonesia. So while it is big news and the signal value is high, take the MSCI decision with a grain of salt.