Asset Allocator: October 2015

 The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

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ASSET ALLOCATOR: October 2015

The what if scenario – emerging markets collapse

In my monthly review I looked in detail at the cautiously optimistic case for slowly increasing exposure to emerging markets. I would contend that the arguments - though not definitive - do on balance favour some increased exposure to EM stocks but I also conceded that there was much that could still go wrong. 

In this short article I want to flag up four particular ideas. These are that: 

  • Chinese equities could fall by an additional 20%
  • The current Asian/EM sell off isn’t that big looking at historic comparisons
  • There is a chance that China could experience a lost decade in terms of returns
  • Commodities could be in the firing line for many more years to come

 Let’s take each of these points in turn. 

First off I think there is some evidence to suggest that the current sell off in Asian stocks hasn’t completely finished. For instance when we look at small/mid cap companies in Korea, especially those in the technology sector, we have seen both strong price performance and multiple expansion in several companies. As a consequence, markets like the KOSDAQ in Korea provide some evidence that sentiment towards emerging markets may not be at capitulation levels as yet and emerging markets may have further to fall. 

The chart below shines a light on the potential for yet more selling of Chinese stocks. It shows returns for the Lyxor ETF tracking the CSI 300 index of local Chinese shares over the period from the beginning of 2014. In particular the chart shows comparative % price returns for this index and the S&P 500. 

Even after the catastrophic price declines of recent months Chinese equities are still ABOVE the levels seen this time last year. In fact if we assume that Chinese corporates generally over the last year have not seen any great increase in profitability, and that local shares should be valued at close to two year lows, why can’t Chinese equities decline by at least another 20 to 30%?

 

The next two tables from analysts at Societe Generale are even more compelling. They show previous Asian bear markets, including the Asian financial crisis last century and the global financial crisis of 2009. These numbers suggest that the recent sub 20% falls are nowhere near as dramatic as previous sell offs.

 

The next chart looks in more detail at specific national and tells an even more extraordinary tale which is that during previous sell offs declines of more than 50% were not unusual. If this pattern was to be repeated we could see a dramatic decline in local confidence.

 

 

I’m not sure that these projections should form the base line of any investor’s analysis – the consensus is probably still that things are bad but not that bad!

But if these fears are even half realised the effect on emerging markets could be brutal. Crucially though the impact of this sell off will varying across the emerging markets universe.

Rowan Dartington Signature’s Guy Stephens recently ran the numbers on the contagion effect throughout both Asia and global emerging markets and suggested that the important features are the size of the export component of a country’s GDP and how much of that goes to China.  “Taking Australia as an example” says Mr Stephens, “in 2014, 21% of their GDP was composed of exports (Source: World Bank) and of that 36% went to China…..Similar characteristics can be seen for Brazil, Chile, Venezuela and Nigeria which have significant reliance on the oil price and commodities.  Their economies and currencies are being devastated at the moment and again, it is difficult to see any improvement on the horizon.  If we observe other high export countries such as Malaysia and Thailand, which export over 75% of their GDP but are not resource intensive, then the inevitable reliance on China becomes apparent.  12% of Malaysian exports go to China, but Singapore and Japan are also important trading partners.  The numbers are similar in Thailand and Taiwan but much of this is interdependent and subject to the location of the end consumer.  It is a complex picture but collectively will be significantly impacted.”

But there is a more worrying possibility which is that although China may avoid the worst form of hard landing, it might nevertheless suffer from a lost decade of lower than expected growth. This theory is predicated on a number of unsettling possibilities, namely that China’s debt levels simply become unsustainable and that growth in the Western developed economies remains below long term trend levels, sapping Chinese exports. A note by analysts at Societe Generale puts the following probabilities on a lost decade of lower Chinese growth – the bank’s analysts reckon that “ China “hard landing” risks remain elevated at 30%, but we see a “lost decade” as a more significant risk at 40%.” In these circumstances the asset allocation options are simple – gold shines, other commodities continue to sink in value. But the biggest risks could actually come in the debt markets. The two charts below from the SG report show that investor appetite for EM corporate debt has massively increased over the last six years  but these investors don’t seem  to understand just how high default levels could go if there was another major crisis.

 

 

And what of equities? A lost decade for China is clearly bad news for everyone in a globally connected market. The chart below suggests that a lost decade could knock as much as 25% of S&P 500 valuations – a hard landing by contrast could result in a massive stockmarket rout. But what of Asian equities in particular? 

 

My October investment theme suggests that Asian equities were probably the most interesting option within the EM space but surely if China does suffer a lost decade of lower growth won’t that knock the region’s equities for six? Curiously not according to the SG analysts who think that EM Asian equities will continue to outperform for a number of reasons including:

“Valuation levels in EM Asia are lower, which provides shelter on the downside for EM Asia relative to the rest of EM

Weight of Energy and Materials in EM Asia is lower at 11% compared with 24% in EM EMEA and 20% in EM Latam. EM Asia underperforms the rest of EM when commodity prices rally and outperforms when commodity prices are weak.”

All of which brings me to the core concern – most industrial and energy commodities will carry on falling in price, extending into a decades long bear market. None of us need to be reminded about the connection between soft Chinese economic growth and the price of commodities. But commodities may be under pricing pressure for other reasons. I’m especially concerned that within the commodities complex  supply has proven to be remarkably elastic in responding to this demand and we have seen a massive flood of new capacity, typified by the North American unconventional energy story and its ongoing struggle with OPEC. 

All this negativity about commodities has powered a profound change in attitudes amongst global investors. Suki Cooper, head of metals research at Barclays, notes many investors now see the sector as a series of more opportunistic short-term investments rather than as a long-term diversifier for portfolios, with a potentially profound impact for asset allocators. 

Rallies might happen, but I am coming to the conclusion the whole sector is in the middle of the wrong kind of supercycle, downwards over a very long period. In From Boom to Bust by Canadian academic David S. Jacks found evidence of cycles lasting 10-35 years, with the last upswing back in the middle of the 1990s. If the current cycle did start then, the peak may have been reached in the early part of this decade, with the potential for at least another 5-10 years of volatile declines, until it hits another trough in the mid-2020s.

And the drivers for this downward push in prices? Chronic oversupply, high inventories, sub-trend global demand growth, and active de-diversification by portfolio-based investors. If the commodity bears are right we may be many years off the bottom.

But I finish with one last optimistic set of numbers for commodity investors. The last table below – also from SG – shows commodity price corrections after previous bouts of market turbulence. Pretty much across the board commodities have now fallen by as much as in previous years.  We could still see some more bad news but I my sense is that if we can avoid either a global recession or a Chinese lost decade, we are probably due an upturn at some point in 2016.

 

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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