Chinese equities have risen steadily higher in 2017 in a stealth bull markets, despite $700 billion in capital flight last year, a fall in the renminbi to 6.90, periodic liquidity squeezes in the Shanghai money market, draconian credit controls, a 166% corporate credit/GDP ratio and President Xi’s consolidation of power over the Beijing Politburo. The world’s smart money, stung by horrific losses in Chinese equities in August 2015 and January 2016, is still underweight China. Fund managers in New York, London and Singapore own the lowest holdings of Chinese equities relative to benchmarks since 2006.
The macro bull case for China makes tactical sense. As producer price inflation and industrial commodities prices rise, the cash flows, profits and collateral value of China’s state owned enterprises also rises. The National People’s Congress rubber stamped Premier Li’s 6.5% GDP growth target. The renminbi has stabilized at lower levels. Beijing has achieved a geopolitical rapprochement with Washington after Trump’s Taiwan gaffe and threats to launch a trade war. The Yellen Fed’s de facto temporary tolerance for US inflation above 2% at the March FOMC is US dollar bearish and thus bullish for the MSCI emerging market index, which is 27% weighted in China. Chinese bank loan growth and EPS momentum has begun to accelerate Capital controls and PBOC rate hikes have also stabilized the renminbi. No wonder the Chinese large cap index fund (symbol FXI) is 39 as I write. The Middle Kingdom is making money for investors even as Hong Kong’s Hang Seng index broke out above 24000. As the world’s largest crude oil importer, China even benefits from the recent 9% fall in Brent and West Texas black gold.
I find the risk reward calculus in Chinese bank shares, the cheapest international lenders in Asia (with good reason) compelling at current levels. Chinese Big Four banks are on the eve of a multi year earnings cycle as net interest margins improve and corporate non-performing loan ratios decline, primarily in China’s rapidly consolidating industrial sector. As the PBOC tightens monetary policy in response to Fed moves, a steeper yuan money market yield curve will fatten Chinese bank interest rates spreads and weaken “shadow banking” rivals. With minimal dependence on international wholesale funding markets due to its 25000 plus branch network in the Mainland, a loan/deposit ratio of only 65% and a valuation of less than 6 times forward earnings makes the Agricultural Bank of China, founded by Great Leap (famine) Forward and Cultural Revolution iconoclast Chairman Mao Tse Tung, a no brainer.
I agree with Morgan Stanley and Dr. Mark Faber’s enthusiasm for China Construction Bank, thanks to its cheap valuation (6X earnings, 5% dividend yield, 0.9 times book value), strong balance sheet above peer 15% returns on equity and vast retail banking network.
Other than banking, Chinese Internet shares offer some of the world’s most profitable online media and growth e-commerce franchises. Tencent Holdings (700 Hong Kong) runs the world’s biggest mobile messaging and social media platform, with 800 million users (no type here. 800 million users) We Chat network. As in the West, online advertising is migrating from desktop PC’s in China to smartphones. Nomura estimates online advertising on social media networks will grow at a 62% compound rate in the next three years. Tencent, with at least a 50% market share of Chinese online ads, is the hyper-growth social media of the zeitgeist, not the overpriced, moronic, overhyped Snap IPO I dissed a month ago that has flamed out on Wall Street.
I was fascinated by Morgan Stanley’s comparative valuation of Internet cloud storage firms, given that cloud will be a foundation technology for the human race in the coming decades akin to electricity. I was not surprised to see Morgan Stanley flag Alibaba (symbol BABA), given its 50% market share in the Chinese public cloud, now a mere $2 billion or 2% of the global market, clear evidence that is one of technology’s embryonic hypergrowth niches. Alibaba could well grow its public cloud business by 80% per annum in the next five years. Alibaba cloud revenues were $1 billion in 2016 but could rise ten times in the next four years. Is this scenario remotely priced into Alibaba shares on the NYSE even at $100? Absolutely not. Jack Ma rocks!
Macro Ideas – The Indian rupee and the NSE Nifty Index are both overvalued
The Indian rupee’s rise to a 16-month high against the US dollar at 65.40 is not surprising given the smoke signals that emerged from the momentary conclaves of Big Daddy (as the Reserve Bank of India is known in the money markets) in Mumbai and the Federal Reserve Board in Washington. Dr. Yellen indicated that the Fed was willing to tolerate a temporary rise in US wage inflation above its dual mandate level of 2%. This is the reason the US Dollar Index tanked from its 102 high to below 100 and the yield on the US Treasury note fell from 2.61% to 2.40%. This was a green light to own the Indian rupee as one of the world’s most attractive high yield currencies. The RBI made the trade a no-brainer once Dr. Urjit Patel decided not to cut the repo rate and keep monetary policy neutral to hedge inflation risk. A hawkish RBI in Mumbai, a dovish Fed in Washington. How could the Indian rupee not appreciate against the US dollar?
Two, the Uttar Pradesh polls were a game changer in Indian politics. The BJP’s landslide win reinforces the relative collapse of the Samajwadi Party and its Congress ally in India’s most populous state. The UP win means Modi will probably win reelection as Prime Minister in the 2019 general election and remain at the helm till 2024. This is hugely reassuring for foreign investors who have staked untold billions of dollars on Modi’s pro-market, reformist agenda, despite his selection of the odious Yogi Adityanath as UP chief minister.
Three, contrary to prognostications of macroeconomic doom after Modi’s shock rupee banknote reform, India delivered 7% GDP growth in the December quarter, the highest in the emerging markets. Three, the Union Budget also demonstrated that the BJP government is willing to commit to fiscal discipline, with a 3.2% budget deficit target.
Four, the fall in oil prices in the past two weeks is positive for the Indian current account deficit, as is the fall in the price of gold since 2011.
Five, Modi’s reforms to boost foreign investment in aviation, insurance, banking etc. reinforced India’s balance of payments and reduced Dalal Street’s reliance on offshore hot money portfolio flows. The surge in FDI in 2016 is unquestionably rupee bullish, as is the implementation of the Goods and Services Tax (GST).
Six, India’s equities market is once again the consensus darling for Wall Street’s emerging market fund managers. The Indian rupee has been positively correlated to a Nifty that has now risen above 9000 and is the most expensive stock market index in Asia. For now, the Indian rupee is on a roll. Yet strong US data a hawkish Federal Reserve could again resurrect King Dollar and the Indian rupee could well depreciate to 67. At Nifty 9000, MSCI India trades at 17.8 times forward earnings, at least 2 full points above its historic average of 15X. Indian equities are also now two sigma (standard deviations) above their mean valuations in the last decade. India also trades at a 34% premium to the Morgan Stanley emerging markets index. I cannot forget that Nifty 9000 proved to be a short term market top in the both March 2015 and September 2016.
While Indian equities deserve to trade at a valuation premium to the emerging markets indices, the scale of the premium makes the Sensex/Nifty too expensive for new money at this time. I am programmed to exit India at 18 times earnings given my analysis of market cycles on Dalal Street since the debacles of 2008. Foreign positioning risk could also prove a sword of Damocles for the Sensex/Nifty indices once Federal Reserve continues to raise interest rates this summer and autumn. However, the “equity culture” among India’s life insurers and mutual funds will broaden domestic participation. It is surely significant that Indian mutual funds own 12% of the float on Dalal Street, below the 20% owned by offshore fund managers. Modi’s rupee banknote reform will boost bank CASA deposits by at least $250 billion – and provide high octane fuel for the stock market. This could explain the stellar 18% performance of the MSCI India country index fund (INDA) in the first three months of 2017. The ghost of E.M. Forster will applaud our financial passage to India!
Stock Pick – The bullish catalyst for French and Italian shares
Europe has now endured Brexit, Trump, the refugee tragedies, Putin’s Ukraine war, a Greek sovereign debt spat, a failed Italian referendum, multiple banking crisis and the prospect of war in the Western Balkans just in 2016. Yet this week is also literally the 60th anniversary of the Treaty of Rome, one of the high points in human history.
Europe’s Stoxx 600 index trades at 1.8 times book value and 14.9 times current earnings. This is not cheap but is relatively modest valuation given that Wall Street trades at 3 times book value and 18 times earnings. Of course, within Europe, there are vast variations in indices and sectors – Italy’s MIB index, for instance, trades at book value. I believe that Emmanuel Macron, the center-left independent candidate, will be the next President of France (though Martin Schultz could well be the next German Chancellor), Europe’s economic growth has begun to accelerate as PMI’s are now in the 54 – 55 range and ECB President Mario Draghi could well engineer a steeper yield curve that will be a steroid shot for battered, unloved, underowned European banks. As global fund managers price out tail risks in Europe and bond yields normalize while the oil drop dampens inflation risk, the case for a valuation rerating in French and Italian equities becomes compelling. Of course, Italy’s politics have been volatile and chaotic since the Florentine Renaissance (actually even much earlier – Caligula, Tiberius and Nero were not exactly exemplary pillars of governance). Political risk in Italy is an existential reality for investors, only the risk premium is now too richly priced.
Valuation alone is seldom a market timing indicator and, to me, never a go/no go indicator. If I am wrong on the French election, all bets are off in European and global equities. Marine Le Pen is not priced into current risk premia and valuation metrics and world finance is not braced for Frexit. However, Europe’s earnings growth cycle has begun to accelerate even as inflation and interest rates rise. This is nirvana for value stocks in the Old World (ex Britain as Article 50 makes me allergic to UK equities and London property in 2017).
My conversational French is not fluent enough in Parisian slang to grasp all the nuances of the Presidential debates but even I could tell that Macron outclassed Le Pen (a chubby bottle blonde housewife from La France Profonde!) and Fillon (a pseudo-Thatcher bureaucratic crook!) in all the key economic and financial issues de jour. This means I adore the très magnifique (0.65 times book value) rerating potential of the Banque Rouge et Noir, also known as Société Générale. This puppy trades at an unjustified 35% discount to the European banking sector, has just appointed Lorenzo Bini Smaghi as chairman and offers a dividend yield of 5%. Is the “Trump dump” reason to change my mind on SocGen? Mais non. The Volatility Index has not gone ballistic over 25. French money center banks have fallen less than their US peers and emerging markets losses are less than the S&P 500 index. The intraday Volatility Index spike to 13.16 does not define a “vol get out” SOS to me. Not yet.
A French diplomat in the 1950’s once said that “I love Germany so much that I am glad there are two of them”. As a lifelong soccer fan, I do remember a world in which the Bonn Bundesrepublik and the Stalinist DDR coexisted, where Checkpoint Charlie divided the two worlds of Cold War Berlin. In times when GDP growth and inflation rises in Europe, high beta German cyclical shares also outperform. This leads me to Daimler, Siemens, Deutsche Börse and Thyssenkrupp. Yet I concede that DAX 12000 makes German equities the most expensive major market in Europe. I see the risk reward calculus more in my favour in Italian equities priced at a mere book value. The best Italian country index fund I know is iShares MSCI Italy (symbol EWI). Since I expect Milan’s MIB to rise to 2500 or at least 25% in the next year right if the jokers in the Quirinale Palace get their act on bank bailouts/political reform right, I now love Bella Italia, the lovely peninsula whose national motto is Mamma, Pasta and Discoteca! If Macron wins the French election, Italian banks will be the macro trade de jour.
It is a cruel irony that Italy’s GDP is still 7% below its 2007 pre-Lehman peak. After the failure of Matteo Renzi’s referendum on political reform, I believe, nothing short of a landslide Cinque Stelle win (O Mamma Mia!) rules out the valuation rerating case for Milan.
