So this is one of those cases where someone was trying to say one thing, but inadvertently made the opposite case.
For weeks we’ve been asking whether concerns emanating from China were on the verge of spilling over into EM more generally.
Our concern is that with EM having already dodged several bullets on the way to outperforming YTD, the space is priced to perfection and thus even more vulnerable to a commodities slump, a Fed tightening cycle, or just general concerns about global growth and trade than it would be had we seen any semblance of a pullback.
On Wednesday we showed you the following chart which certainly seems to presage nothing good for EM equities if you believe Morgan Stanley’s “leading trade indicator”:
Recall that the China story has two components: 1) PBoC efforts to rein in leverage by hiking OMO rates, draining liquidity, and cracking down on shadow banking, and 2) the macro story which has recently seen PMIs, trade data, and factory gate prices all rolling over. Of course those two things are interrelated. That is, if China wants to support the economy, they can’t very well start curtailing credit expansion.
So far, the damage has been contained thanks in no small part to a stable yuan. We’ll see how long that lasts.
Coming full circle to what we said at the outset, Goldman set out to look at how EM equities that are tethered to commodities and the cycle more generally have held up of late. Their conclusion is ostensibly encouraging, but from where we’re sitting, it only underscores our “priced to perfection” narrative and thus makes things seem even more precarious.
Read below and decide for yourself…
China growth fears have resurfaced in client conversations over the past two weeks, as investors have become increasingly worried regarding the potential of “over-tightening” from policymakers. Chinese rates (including interbank rates) have been climbing through much of Q4 last year and early 2017, but these fears have grown more acute as commodity prices have moved sharply lower and China’s PMI has declined.
While China’s nominal growth has likely peaked, this tightening is taking place in the context of a very strong Q1 – real GDP growth was 6.9% yoy, well above the government’s target of 6.5% – and real growth is likely to be solidly at or above the target levels for coming quarters as well. So on the face of it, it is hard to square this with the severe pressure in commodity markets. Since mid-April, Brent has fallen by 13%; month-to-date, copper has also sold off sharply by 5%. Our Commodities team views the recent price action as ‘over-done’ and remains positive on the complex given supportive global demand, though recognising that China risks can certainly weigh on commodity demand if growth further falters. We approach this issue from an equity market perspective – to assess the degree to which China growth fears that have manifested in commodities are playing out in broader cyclical equities in China itself but also EM more broadly.
Within EM equities, while MSCI EM has continued to rally, commodity-related equities have mirrored the damage in the commodity complex. In particular, we break down the equity performance of Commodities vs. Defensives into China and EM ex-China (see Exhibit 1). EM ex-China commodity companies have been underperforming defensives since mid-February, whereas in China itself the underperformance of commodity equities has been more recent – in the past week, China commodity equities have sold off very sharply, along with continued underperformance of commodity companies in the rest of EM.
However, to the extent that the source of this commodity damage is concerns about broader demand growth in China and the region, it should be reflected not just in commodity equities but also in broader cyclical underperformance in Chinese and regional equities.In fact, the opposite is true when looking at cyclical companies (see Exhibit 2). Chinese Cyclicals (including consumer discretionaries, industrials and tech) have moved sharply higher in recent months. At the beginning of May, although China Cyclicals priced in some concern over growth risk, markets quickly reversed that and have again reached new highs. A very similar picture can be seen in Asia equities more broadly, where cyclicals have sharply outperformed defensives recently, suggesting little concern about a cyclical slowdown. And while more muted than China or Asia, in EM ex-China, the same trend of broad cyclical outperformance is clear with little sign of slowing down.
In other words, there is little in the pricing of broad cyclical equities in China, Asia Pacific or the EM region to indicate heightened concern about cyclical activity – if anything, these markets indicate a buoyant cyclical picture.Of course it is possible that commodities are the ‘canary in the coalmine’ that indicate coming cyclical pressure that broader cyclical equities have yet to price. But in our view this more sanguine equity market perspective is more consistent with an expectation of still firm cyclical activity in China and the region in coming months.
So yeah… we’re still going with this…