Wednesday, August 26, 2015

From the trenches - A manager's view on China...

We've been looking at, and investing in, the New China Capital China Equity Fund, run by Mansfield Mok, for a while now... it's been hit hard over the last month or two as a consequence of the brutal sell off in Chinese equities.

Although one would understand a tendency for him to talk his own book, Mansfield has always struck us as being pretty objective... herewith his views on the recent slump:

"We believe the correction in Chinese equities is at odds with China’s fundamentals. China’s economy is much healthier than at the time of the 1997 Asian crisis, with huge FX reserves (34% of GDP and the largest in the world at over $3.5 trillion), a healthy current account surplus (2.8% of GDP) as well as a moderate fiscal deficit (2.3% of GDP). Furthermore, China is unusual among large economies in that the authorities still have plenty of means available to stimulate growth via both fiscal and monetary means. The current low inflation rate of 1.6% indicates that China has room to maintain easy monetary policy and the potential to add more stimulus through further cuts in interest rates and the Reserve Requirement Ratio (RRR) should it need to do so."

"Even though the People’s Bank of China (PBOC) has [just] announced a reduction in interest rates and lowered the RRR, there remains plenty of room for further cuts if necessary. China’s large FX reserves are available to help support the currency whilst the relatively low ratio of debt-to-GDP means there is room for additional fiscal stimulus to help mitigate economic weakness. However, these positive factors are not reflected in the Chinese equity market (the Hong Kong listed H share and red chip stocks) due to the factors highlighted above."

"We consider the recent sharp decline in offshore Chinese equities to be due more to a downward spiral of redemption selling in Emerging Market funds rather than based on fundamentals and the corporate outlook."

"The cumulative inflow into Chinese equities has fallen back to the early 2010 level, suggesting that Chinese equities are under-owned. Stock valuations also look attractive with the MSCI China index trading at historically low multiples of 1.2x 2015 price-to-book (P/B) and 9.5x 2015 price-to-equity (P/E); the China H share index (also known as the Hang Seng China Enterprises index) is trading at P/B and P/E multiples of around 1.0x and 7.0x respectively." 

"We believe current valuations brought about by recent panic selling could represent a good investment opportunity for investors on a 12-month view."

Our view is similar, if a little more cautious in the short-term, given some recent blunders by the government - with sentiment so fragile, it seems strange for the government to opt to introduce another element of uncertainty by kicking off a devaluation of the RMB a couple of weeks ago. However, that's more an issue of timing than anything else.

We also feel, that the broader implications of China's recent actions have been overstated in terms of global markets. Back to Mansfield:

"The combination of lower commodity prices and continued easy global monetary policy will be stimulative for global consumers, something we think will eventually come to be appreciated by markets. We anticipate a shift in investor sentiment in late September/early October on the back of (i) supportive easy monetary policies and fiscal stimulus, (ii) a clearer picture of the path of US interest rates following the FOMC meeting on 17th September, (iii) ongoing implementation of corporate reform and SOE restructuring, and (iv) an improvement in earnings following cuts to interest rates and the RRR from early 2015."



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Sunday, August 23, 2015

Time to buy...?

A good piece from UBS this morning looks at the developing blood bath in markets over the last week (and continued into today). Last Friday's poor PMI data out of China was the immediate trigger for a sharp sell-off, although this had been kicked off the week before by China's decision to devalue the Yuan... the PMI data seemed to confirm the worst fears that the devaluation had been prompted by a significant slow down in the economy.

The short-term looks nasty, brutish and (hopefully) short.  

UBS notes that..."Investors should brace for further volatility. But we expect this bout of risk aversion to pass, with equities in developed markets resuming their upward trend. Despite the ongoing weakness in some emerging markets, especially China, Brazil, and Russia, domestic drivers in the US and Europe have not deteriorated significantly and we expect growth to remain on track in these economically larger regions. We also believe central banks stand ready to provide support if sentiment worsens further..."

After the dust has settled, the positives seem likely to have remained in place, and suggest that markets now look 10% more attractive since they are now 10% cheaper.

Our more optimistic view rests on 5 core points:

(1) The economies of the US, Europe and Japan are looking solid, and likely to see a continuation of gradually improving earnings.
(2) The China market meltdown has been much more brutal than we anticipated, but reflect a relatively underdeveloped investment culture and the ripple effects of margin selling elsewhere in the region, compounded by a series of intentional or unintentional regional currency devaluations. However, as noted by UBS: "...Last week’s economic data was not bad enough to change our fundamental outlook for global growth. The manufacturing side of the Chinese economy has been struggling for some time and the construction sector has been hit by oversupply and soft demand. We in CIO are not expecting conditions to worsen in China. Rather we believe that momentum will gradually pick up towards year-end as accumulated easing measures begin to take effect. That said, China has the capacity and willingness to enact more policy measures...."
(3) The slide in commodity prices - except for the energy companies - are broadly beneficial and will keep the lid on inflation for the foreseeable future. Margins will therefore benefit as costs are stable or decline.
(4) The Fed has been poised for an interest rate increase and signalling that for possibly as early as next month. The likelihood is increasing that this will be pushed back in the face of this broad volatility.
(5) Technically, a whole bunch of markets now look oversold - especially in the Emerging Markets space. Whilst we would not yet jump in to buy these (with the exception of India and Vietnam) given currency uncertainties, valuations are getting back into interesting territory. We've been underweight Asia & EM for the last six months, and will remain so for the time being, but at some stage the attractiveness will become compelling. In the meantime, the recent sell off creates opportunities in the US, Europe and Japan look evident. 

We believe the recent falls in markets are – barring an unlikely recession in China – exaggerating the risks and ignoring the underlying positives. Whilst, in the short term, action by the Chinese government to reflate their economy is key short term, we expect markets to re-focus on a gradual global economic recovery led by developed economies. Although emerging markets have fallen the most, we are wary of increasing exposures in these until after the the US Fed moves on interest rates (or at least, gives a clearer indication of intent).

Markets have fallen to the higher-end of our re-entry targets and offer decent upside, of 15-20%, to our estimated fair value looking-out 12 months. At some stage, cash will come off the sidelines since we still think that there remain few alternatives to equity on the basis of valuation and expected returns... 

It's a tough call, but since it's impossible to catch the bottom exactly, the falls we're seeing today look like a good opportunity to start buying. The ACWI global equity index is now down almost 10% from its high of the year, set on May 21st, which is a technical correction. The US is now down 7.5% (mostly in the last 4 weeks). 

So... we maintain our overweight on developed markets and our underweight on emerging markets, and to that end, we will cautiously start deploying some of our cash – initially 5% - into developed equity markets. Should markets fall further, we will look to add more aggressively.

Steve & Justin


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