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Re-opening with Hope

May 26, 2020

• Economic data displays fewer really bad surprises
• Some country and sector rotation within equity markets
• Emerging market debt showing good momentum
• India – a market waiting to perform
• Chinese assets with domestic support but international challenges

We would frame the current market phase as a ‘re-opening filled with hope’. Markets are already enjoying slightly better economic news and are discounting that recovery will take hold. However, we have to keep in the back of our minds that a vaccine still appears a long way off despite the odd announcement of promising (but not conclusive) medical trials. Also, as countries re-open some re-acceleration of COVID-19 cases are inevitable – we hope that they will be held in check. Our best advice is that if investors commit fresh funds to the markets, they buy assets that have not already discounted a perfect recovery. You may want to look at selective emerging markets.

Economic data is getting better at least to the extent that the surprises are no longer as bad as they were. The Citigroup economic surprise index for the major economies has improved from a level of minus 138 at the beginning of May to a current level of minus 96. The index measures the degree to which economic data is coming in above or below expectations.

‘Better’ news, or at least ‘not as bad as before’ news is leading to some rotation of equity market performance away from the leadership of the Nasdaq and S&P500. The US small-cap Russell 2000 index was up 7.9% on the week, outpacing the S&P (+3.2%) by a good margin. Pockets of European equities were up over 5% last week (German DAX and Swedish OMX). Left behind at the moment are the Asian markets which were very mixed with the Nikkei up just 1.8% and China-related markets dragged down by geopolitical challenges.

In our tactical asset allocation strategy meeting this past week, we had a long discussion about the merits of tactically moving into emerging markets and particularly Asia. Emerging market debt has already started to rally, and it feels that there is some momentum behind it. Many of the EM central banks have already cut interest rates to low levels. Last week Turkey and South Africa cut rates by 50bps. Many have indicated that they are ready with some forms of quantitative easing to support their government’s spending plans.

Given that global inflation is likely to remain biased lower, we should expect emerging countries to cut interest rates further in the coming months. Lower rates could spur further good performance from emerging market debt. The JPMorgan Emerging Market Bond Index (EMBI) spread has fallen from a peak of over 661bps on March to 490bps. A move below 450bps looks quite possible in the coming weeks. There are some crowded trades such as EM sovereigns where investor positioning is already high, hence for value you may need to look to EM high yield.

India is one equity market to keep an eye on. While news on COVID-19 and the economy remains very difficult, some elements of the market have got down to extremes. India’s mid-cap index has seen its worst sell-off since 2008 and is still down 30% from its February highs. The Nifty rebounded with global markets from its March lows but has since been marooned in a tight trading range. The market is disappointed with the seeming lack of action on the part of policymakers. Still, we have to believe that the government is waiting until they announce a more significant easing of the lockdown before committing to more substantial government spending. The latest fiscal ease was a paltry 0.9% of GDP, whereas other countries are spending around 6%; remember New Zealand the week before last announcing spending equivalent to 16% of GDP. We have to believe that the Indian government will respond with a more aggressive easing of fiscal policy to inspire the equity market to much higher levels. The fall in the oil price brings significant support for the economy. Brent oil is nearly half of its level of a year ago, significantly helping the current account and putting further downward pressure on domestic inflation. Each $10 off oil prices typically helps the country’s current account balance by $13 billion. Consumer price inflation which had picked up from 2% to over 7% in 2020 should fall, although supply shortages, particularly for pulses, have pushed the inflation higher in the short term.

In the meantime, the Reserve Bank of India has cut interest rates 3.35%, within ten basis points of the 2009 low. Indeed, the RBI surprised the markets by reducing the rate two weeks earlier than expected. In 2009 the record-low interest rates inspired the Indian equity market to double in the following 18 months.

Longer-term, India has the opportunity to gain from China’s challenges. China’s trade spat with Australia is likely to lead to the announcement of closer ties between India and Australia at the two countries virtual summit between their respective Prime Ministers. A global theme of diversifying supply lines should also play into India’s hands to the extent that it can be ready and prepared for the opportunities at hand.

China is another key emerging market that sets a dilemma for asset allocators at the moment. Looser monetary policy and a significant increase in government spending help the cause of the equity market. The central bank appears to be targeting much higher money supply growth. Economists expect a further 50bps of rate cuts in the coming months, along with a further reduction in the reserve ratio, thus releasing liquidity into the economy. The economy will also be helped by a fiscal package that equates to 8.4% of GDP with an increasing focus on job creation.

Unfortunately, the economic picture has to be seen in the global context of investor concern at the ongoing political spat with the United States and the international concern with China’s intention to potentially impose National security legislation into Hong Kong’s basic law. Investors will continue to fret that ahead of a US Presidential election, President Trump may keep up the negative rhetoric around China and thus limit international interest in the equity market. EPFR data shows that dedicated China equity funds have seen outflows in recent weeks. However, EPFR also reports that dedicated Asian funds have been increasing their allocations to Chinese equities. We would advise international investors to gain access to China through actively managed funds that can play the positive themes (domestic recovery, consumer staples, real estate) and avoid the sectors burdened by trade issues (communications and technology).

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