China: The center of EM Pessimism
Lingering headwinds led to a global growth scare emanating last quarter from the emerging markets, with the epicenter in China. In a sense, it is a repeat of the growth scares that we have had over the past few years, but this time its origin lies in the emerging markets rather than Europe, Japan or even, to go back a few years, the U.S. Our heat map survey of the world's purchasing managers' indexes for manufacturing in September illustrates the nature of the current scare (EXHIBIT 1). The emerging markets' aggregate PMI, at 48.4, falls short of the 50 mark that separates an expansionary from a recessionary reading. Further down the chart, the economy-by-economy figures show that China is lagging even the EM aggregate.
A global growth scare centered in the emerging markets (and particularly China)
Exhibit 1: Global purchasing managers' index for manufacturing
Source: Markit, J.P. Morgan Asset Management, Guide to the Markets-U.S.; data as of September 30, 2015. Heat map colors are based on PMI relative to the 50 level, which indicates acceleration or deceleration of the sector, for the time period shown.
Layer this outlook on top of the lingering headwinds and it's easy to see why emerging market equities' performance has been forgettable this year. With the exception of dividends, every component of asset class returns—earnings growth, valuations and especially currency—has detracted from performance.
A "New China" growth engine (services) is supplanting "Old China" (manufacturing)
We believe that China is undergoing a rotation from a manufacturing-based economy to one more evenly balanced with consumption and services. A comparison of the Chinese services PMI with the manufacturing PMI supports this observation (EXHIBIT 2).
"Old China" struggles while "New China" holds its own
Exhibit 2: China PMI output spread; services vs. manufacturing
Source: Markit, J.P. Morgan Asset Management; data as of September 30, 2015
The exhibit's shaded area, indicating the spread between the two PMIs (services minus manufacturing), traces the rotation from manufacturing and investment spending to services-led GDP growth. It prompts three important observations:
- The services PMI, which generally garners fewer headlines than its manufacturing counterpart and includes the Internet sector, has held up reasonably well, even as the manufacturing PMI has weakened.
- The rotation to a service economy is taking place by design, not by accident. Chinese authorities have talked for many years about shifting the growth model in China away from an overreliance on investment, manufacturing and exports.
- The rotation from manufacturing-led growth toward services growth has profound global implications, since the services sector tends to be less trade—and commodity—intensive than manufacturing.
The consumption tilt in China's economy has meant slower growth than the investment-driven manufacturing boom that preceded it. Using our proprietary measures, which incorporate data on domestic supply and demand to compare with the official GDP statistics, we calculate Chinese year-over-year GDP growth to be approximately 5% vs. the official 7% number—very much at the low end of the range that we have seen over the past decade. Nevertheless, it is important to point out that neither the supply nor the demand indices are decelerating further. Though many analysts think that the risks are to the downside, the so-called hard landing is not evident in the data.
Statistics from the critically important real estate sector lend further support to a soft-landing thesis. As prices are stabilizing more broadly across China, sales volumes have held their own pretty well (EXHIBIT 3A). In fact, the run rate of sales is beginning to whittle away at the overhang of inventory in the housing market, especially in the smaller Tier 3 cities (EXHIBIT 3B).
Chinese real estate inventory starting to turn amid improving sales volumes
Exhibit 3A: Real estate sales volumes
Source: CPREIS, UBS estimates; data as of September 30, 2015.
Top 41 cities' sales volume, excluding Harbin.
Exhibit 3B: Inventory levels by city type
Source: CPREIS, UBS estimates; data as of August 31, 2015.
India: A bastion of EM optimism
Alongside deepening pessimism on China, investor sentiment—including our own—has embraced the reform and recovery story in India. However, India's equity valuations have risen and are trading not only at premiums to both the EM and Asia ex-Japan universes but at the high end of their own ranges dating back 15 years. In short, we need to investigate how much of those premia can be justified by fundamental positives.
In terms of the fundamental story, several aspects have unfolded favorably for India. To begin with, it has been on the right side of the commodities super-cycle reversal. The collapse in oil prices has greatly benefited the Indian economy, as the country is a net energy importer. The government has taken advantage of the fall in oil prices by reducing energy subsidies and using those funds to increase infrastructure spending while shrinking the budget deficit. Lower prices on imported energy have also enabled India to trim its current account deficit, which a few years ago was approaching 4%–5% of GDP. Assuming that oil prices remain in their current range, the Indian current account position is likely to be roughly neutral over the next year or two.
The government's commitment to economic reform has augmented the nation's good fortune. Recent headlines have highlighted legislative challenges to the government's reform agenda, but administrative reforms are proceeding, increasing the number of public and private projects being started and already in the pipeline. Complementing the administrative initiatives, the central bank's campaign to target inflation at 4% and lower inflation expectations has gained traction. Until recently, the Indian central bank's campaign emphasized tight monetary policy. Over the past month, however, the bank has recommenced the easing cycle, which we regard as a signal that it believes that inflation targeting is succeeding, and that it is now more willing to promote growth.
Can Indian equities justify their premium?
The question that follows is how much upside cyclical leverage Indian corporates and the Indian market have. India had one of the emerging world's most severe growth slowdowns beginning in 2011. By our calculations, the Indian economy is now operating about 2 percentage points below potential. If the cyclical upside were to close that gap, then arguably profits today would be running about 40% below a top-down inferred normal.
The same analysis would show an output gap for emerging markets as a whole, but much smaller than India's. Inferring the gap between current EM earnings relative to a notional normal, it is about 24% vs. India's 40%. Examining valuation multiples on these "normal" earnings per share levels, we deduce that India's valuation premium is reduced but not eliminated, presuming that profitability normalizes for the broad emerging markets as well as for India. In short, valuation premia high-light the imperative for the Indian economic and earnings recovery to get under way over the coming months.
Amid crisis fears, have EM valuations hit a crisis bottom?
The steep decline in EM currencies—and the correspondingly sharp rise in the dollar—have driven the currencies down to levels not seen since the Asian crisis. While EM currencies remain broadly beaten down, we are beginning to see a dispersion of valuations, with commodity exporters appearing the cheapest (particularly the Brazilian real).
Applying the same methods we use to value EM currencies to the U.S. dollar, we calculate that the dollar has climbed about 12%–15% above fair value. That approach shows previous USD peaks in 1985 and in 2002 at 20%–25% above fair value, suggesting that the dollar rally is advanced but not yet complete. In terms of underlying equity market valuations, EM shares are trading between 1.4x and 1.5x price-to-book value, which is the top end of the band that has been "buy" territory longer-term, but above the parity levels seen in the 1998 and 2008 crises. Measuring fundamental price-to-earnings ratios by looking at price relative to 10-year smoothed earnings, the latest leg of correction leaves emerging markets as the unambiguously cheap segment of global equity on a fundamental basis (EXHIBIT 4).
EM valuations: Further de-rating leaves fundamental price-to-earnings ratios back at lows
Exhibit 4: Price-to-10-year average earnings (X)
Source: IBES, MSCI, J.P. Morgan Asset Management; data as of end September 30, 2015.
Cyclically adjusted price-to-earnings multiple uses 10-year average earnings per share.
Within the asset class, we find the dominant opportunities in North Asia. We continue to overweight China H shares, along with Taiwan and to a lessening degree Korea. Importantly, we are still avoiding most of Latin America and many of the commodity-tilted markets, largely because, with the exception of Russia, valuations simply haven't become cheap enough.
In sum, while we do not believe an EM crisis is under way or inevitable, we believe emerging markets equities are still range-bound, constrained by the triumvirate of headwinds discussed earlier. Valuations are not sufficiently cheap to prompt a tactical "buy today" mentality. However, they are cheap enough (including consideration of the EM currency de-rating) to encourage investors to be setting valuation or fundamental "guideposts" to add to the asset class rather than run from it because of the news flow and worries that have overtaken investors.