Investment Strategy:  First Quarter 2020 – Specific Market Reviews: Emerging Markets and Asia

• 2019 was not a good year for EM economies. They have been the major victim of the trade wars as ‘Factory Asia’ is the major supply chain manufacturer and trading partner of both the US and China. Idiosyncratic issues for India, Mexico, Argentina and South Africa haven’t helped either. Maybe though the headwinds are abating and the markets produced strong returns at the end of the year. The temporary trade truce is good news, as is much looser US monetary policy and the potential for a weaker dollar. 
• Emerging Markets as a bloc have produced decent returns this year with the MSCI EM Index returning 18% in local currency and 14% in GBP, though lagging developed market returns. As usual, there has been a wide diversity of return between the individual markets which shouldn’t be viewed as a homogenous bloc. MSCI Russia was the standout rising by a whopping 46% in GBP, made up of a 38% local currency return and, unusually, an 8% strengthening of the rouble. MSCI China has risen around 23% in local currency but 19% in GBP and Brazil 31% in local currency but 21% in GBP, showing the importance of FX in returns to UK-based investors. India was the laggard returning 10% in local and only 3% in GBP.
• If a stock had growing eps, expanding margins and a low valuation you’d buy the pants off it. So why is nobody buying Japan, the only stock market in the world with these fundamentals? If only it were so simple, given that the one thing the Japanese stock market specialises in is false dawns. The Nikkei 225 peaked at 38,916 in 1989 on a P/E of 70 and a dividend yield of 0.5%. It bottomed at 7,000 in 2009 and today stands at 23,656, so not a bad decade, but not such a good 30 years. So where are we now? Japan is still mired in disinflationary quicksand with growth under further pressure from last year’s rise in VAT.  Corporate Japan though is in good nick. Half the companies in the TOPIX index have net cash on their balance sheet and actually paying out to shareholders so the market yields 2.7% on a forward P/E of only around 12x, making it the cheapest of the developed markets. It’s the hope that kills you, but it springs eternal. 
• It has been a difficult year for Hong Kong with mass protests and demonstrations for much of the year. It’s a problem Beijing doesn’t want to own but is one of its own making with the iron fist of Xi Jinping being the primary cause of the turmoil as he tries to force central control over outlying parts of China such as HK, Buddhist Tibet and Muslim Xinjiang. The ‘one country, two systems’ accord is officially due to expire in 2047, but HK locals see themselves as being forced to accept central Beijing control well before then. As a consequence, the Hong Kong stock market has been a big laggard this year, rising around 10%, half that of other Asian markets.

• Trade talks dominate market sentiment towards China and with GDP forecast to slip below 6% this year, it was no surprise that a Phase 1 ‘holding operation’ agreement was reached, satisfying the political needs of both Trump and Xi.
• The Chinese economy is facing plenty of challenges; the corporate sector is over-indebted, the household sector is heavily exposed to the residential property market, and the manufacturing sector is struggling to maintain its past momentum, especially in the face of the trade tariffs. However, there are always plenty of levers in a central command economy to keep the ship afloat. China will want to keep growth steady but no more as it is mindful of controlling existing credit bubbles and making sure it doesn’t create any more. 
• Actually, I’ve just committed the crime everybody else does which is to try and analyse the unanalysable Chinese economy. There are three things you need to know. Common sense tells you that as an economy gets ever bigger its y/y growth rate will slow as the starting point is always larger. Secondly, the numbers are made up anyway. Thirdly, China won’t be providing the hurricane tailwind to growth it did in 2009/10 but will do enough to keep itself ticking over very nicely indeed thank you, which will pleasingly help turn the wheels of industry and commerce everywhere else as well. 
• One of the surprises of the last decade was that the EMs produced returns only a half that of developed markets despite some significant improvements in their fundamentals with many emerging economies now having increasingly robust currency regimes and stronger public finances than developed economies. These markets look cheap with MSCI EM Index trading on a forward P/E of 13x which is a fairly wide discount by  historic standards to the developed markets with the MSCI World index trading on 17x forward earnings. The fate of the EMs tends to be in the hands of others, notably US monetary policy and the trade wars, but these markets are cheap, unloved, with some potentially positive catalysts…..interesting.

Summary: Asian and EM remain high risk/reward stock markets but their fundamentals are improving and they will benefit from a more dovish US monetary policy and a stalling dollar. The trade war remains a key driver for many of these markets but if peace breaks out, then these cheap, unloved markets could have a year in the sun.