China should be at the front of investors' minds when considering expectations for wider emerging markets this year, writes GAM's James McDaid...
This year held such promise after what was a very respectable 2013: developed markets cantered along nicely, European calamity was avoided, tapering became part of everyday lexicon used by both chief investment officers and taxi drivers, and the laggards of the last few years, emerging markets, had the potential to become beneficiaries of an improving global economy.
Alas, these hopes were dashed as the start of the year brought with it gloomy days to both the skies and traders’ screens.
Volatility has spiked up as a new gang – the ‘fragile five’ (India, Indonesia, Brazil, Turkey and South Africa) – brought an element of fear back on a global scale. Worried about an exodus from countries with economic imbalances and perilously high inflation, emerging market central banks tried to a stem a fall in their currencies by raising interest rates.
China leads the way
The results went against generally accepted monetary tightening principle – some of the currencies continued to fall. Factor in a slowing China, and another $10bn coming off the Fed’s monthly bond purchases, and investors have rightly eased back on any optimism they had coming into the year.
A capitulation within emerging markets has been on the cards for some time now. Once the current batch of emerging market sellers has finished, it could be that most of the ‘hot’ money has gone and the opportunistic investors return, enticed by already attractive valuations.
However, policy decisions by emerging market central bankers could prolong the situation. For instance, if capital controls were implemented to prevent further outflows, the situation could get much worse.
China should at the front of investors’ minds when considering expectations for the months ahead. There are various factors to consider, among them the regime changes announced at the third plenum in November, a slowdown in the economic growth rate and the shadow banking system.
The third plenum reforms are a tangible sign that positive change is afoot in almost all walks of Chinese life. For instance, there are land and property reforms for the rural population, demographic positives with the amendments to the one-child policy, allowing the market to play a decisive role in resource allocation, and a plan to protect the environment from (further) damage.
Naturally, these changes will not happen overnight, nor will they bring immediate gain for investors in China; however, what they do point to, is a shift in focus from ‘quantity of growth’ to ‘quality of growth’ which will set the country on a more sustainable path.
Of more immediate concern is the breakneck increase in wealth management products in China’s gigantic shadow banking system. In essence, these products are marketed at people wanting a higher yield than they can get from savings accounts.
Like mortgage-backed securities in the US before the financial crisis, many investors do not fully understand how the higher yields are generated or the inherent risks within the product. Even a former chairman of the Bank of China has referred to wealth management products as a massive Ponzi scheme.
If, as has already happened several times, these schemes begin to default en masse with no guarantees in place, we could witness an almighty level of panic starting off in China and most likely spreading beyond.
With the figures involved in the trillions, it is questionable whether the Chinese State has both the ability and the will to avert a new financial crisis. If investing in Chinese banks, one must be especially aware of the risks involved.
This aside, the growth of an increasingly savvy middle class in China (McKinsey forecasts that the disposable income of China’s urban population will almost treble by 2022) translates into an almost perpetual market for companies that have the foresight to market themselves properly to a discerning Chinese consumer. Luxury brands, including cosmetics and premium drinks, should do especially well from this.
Holding emerging markets, including China, has been sore during the past few years and it seems the majority are now scrambling for the exit. With valuations becoming more and more attractive every day, and a long-term improvement in China now underway, selective bets against the crowd might be a better approach.
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