Hermes: Not all bad news in Chinese markets
12 January 2016 London
Image: Shutterstock
The market sell-off in China has led to a spike in short-term repo rates but, in the long term, “fundamental reform” is required in order to turn the jurisdictions fortunes around, according to Gary Greenberg, head of emerging markets and lead portfolio manager at Hermes Investment Management.
He also suggested, however, that 2016 is the year to establish a position in emerging markets such as China.
Chinese markets have continued to fall, Greenberg said, but the government withdrawing liquidity has led to an increase in short-term repo rates. The stock market, however, has dipped by 5.3 percent.
As ‘circuit breakers’ were withdrawn, there was no opportunity for the kind of selling that has intervened in similar situations in the past.
Greenberg said: “Most interestingly, [head of the state council] Li Keqiang ruled out strong stimulus to boost demand. This supports the move to supply-side economics proposed by President Xi Jinping.”
In the long term, Greenburg suggested, significant changes will be essential to a successful future, and that means, “increasing efficiency and productivity rather than mobilising yet more capital”.
While China’s growth model will have to adapt, it will be difficult to change the drivers of the economy, and there is some doubt over whether authorities can make the changes without falling in to a crisis.
Greenburg said: “How can an economy in which investment is nearly 50 percent of GDP and consumption less than 40 percent, evolve to one in which consumption is over 60 percent of GDP and investment under 30 percent, in several years?”
This is further complicated by the dominance of retail investors in domestic Chinese markets – investors that have short-term horizons and few tools for valuing stocks, and that follow momentum of price shares, earnings, or economic policy.
“Therefore, when the government hints at stimulus, regardless of whether or not stimulus will result in better long-term prospects for the country (and it is unlikely to, given its debt-to-GDP ratio is nearing 300 percent), retail investors plunge in.”
“On the other hand, when reforms are put forward these investors sell, since reforms spell short-term pain as excess capacity is cut.”
Institutional investors are more likely to make short-term sacrifices for long-term gains, Greenberg said. He added: “In contrast, Chinese stock markets gyrate wildly at such a crossroad.”
According to Greenberg, developed markets are outperforming emerging markets because of underperformance on the bottom line in emerging markets. As global growth has slowed, so too has profitability.
He suggested that emerging markets may appear to offer a cheap investment with a low benchmark, but as profitability suffers, the price-to-earnings ratio is less appealing.
However improving the picture for China may not be easy. Greenberg said: “A brighter outlook will probably require some combination of lower valuations, currency depreciation of 5 to 10 percent, a change in the trend of US dollar strength, a bottoming of commodities markets, stabilisation of the RMB and local markets, and for corporate margins to improve.”
He predicted that stabilisation of commodities and margins will begin in 2016, become more evident in 2017 and become a theme in 2018.
“Therefore, this year is the one in which to initiate a position in emerging markets, before building a strong overweight next year ahead of enjoying the ride in 2018.”
He concluded: “Periods of panic, such as now, are typically good times to look for stock ideas.”
“While the valuation of the benchmark is not yet compelling on all measures, this type of market results in the mispricing of companies, which can provide real long-term opportunities.”
He also suggested, however, that 2016 is the year to establish a position in emerging markets such as China.
Chinese markets have continued to fall, Greenberg said, but the government withdrawing liquidity has led to an increase in short-term repo rates. The stock market, however, has dipped by 5.3 percent.
As ‘circuit breakers’ were withdrawn, there was no opportunity for the kind of selling that has intervened in similar situations in the past.
Greenberg said: “Most interestingly, [head of the state council] Li Keqiang ruled out strong stimulus to boost demand. This supports the move to supply-side economics proposed by President Xi Jinping.”
In the long term, Greenburg suggested, significant changes will be essential to a successful future, and that means, “increasing efficiency and productivity rather than mobilising yet more capital”.
While China’s growth model will have to adapt, it will be difficult to change the drivers of the economy, and there is some doubt over whether authorities can make the changes without falling in to a crisis.
Greenburg said: “How can an economy in which investment is nearly 50 percent of GDP and consumption less than 40 percent, evolve to one in which consumption is over 60 percent of GDP and investment under 30 percent, in several years?”
This is further complicated by the dominance of retail investors in domestic Chinese markets – investors that have short-term horizons and few tools for valuing stocks, and that follow momentum of price shares, earnings, or economic policy.
“Therefore, when the government hints at stimulus, regardless of whether or not stimulus will result in better long-term prospects for the country (and it is unlikely to, given its debt-to-GDP ratio is nearing 300 percent), retail investors plunge in.”
“On the other hand, when reforms are put forward these investors sell, since reforms spell short-term pain as excess capacity is cut.”
Institutional investors are more likely to make short-term sacrifices for long-term gains, Greenberg said. He added: “In contrast, Chinese stock markets gyrate wildly at such a crossroad.”
According to Greenberg, developed markets are outperforming emerging markets because of underperformance on the bottom line in emerging markets. As global growth has slowed, so too has profitability.
He suggested that emerging markets may appear to offer a cheap investment with a low benchmark, but as profitability suffers, the price-to-earnings ratio is less appealing.
However improving the picture for China may not be easy. Greenberg said: “A brighter outlook will probably require some combination of lower valuations, currency depreciation of 5 to 10 percent, a change in the trend of US dollar strength, a bottoming of commodities markets, stabilisation of the RMB and local markets, and for corporate margins to improve.”
He predicted that stabilisation of commodities and margins will begin in 2016, become more evident in 2017 and become a theme in 2018.
“Therefore, this year is the one in which to initiate a position in emerging markets, before building a strong overweight next year ahead of enjoying the ride in 2018.”
He concluded: “Periods of panic, such as now, are typically good times to look for stock ideas.”
“While the valuation of the benchmark is not yet compelling on all measures, this type of market results in the mispricing of companies, which can provide real long-term opportunities.”
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