Download Emerging Markets: China, Challenges and Volatility

January 11, 2013
31 January 2016
China, Challenges and Volatility
Q&A on Emerging Markets
SUMMARY
•
Emerging market underperformance stemmed from two main causes – the Fed rate
hike and concerns on China.
•
Nonetheless, we remain optimistic about emerging markets, emerging markets have,
in general, experienced strong historical growth trends and we consider many of the
factors driving recent volatility to be temporary.
•
As we look forward, it is important to note that times of stress in financial markets
can offer the largest upside potential in the medium term.
Why did emerging markets underperform in 2015?
In our view, there have been two main factors contributing to
emerging markets’ performance over the past year: the
anticipation of and lead up to the US Federal Reserve’s (Fed)
interest rate hike and concern about slowing economic growth
in China. Weakness in commodity prices and emerging market
currencies also further pressured stock market performances in
emerging markets.
Historically, we have seen similar sharp market gyrations
Mark Mobius, Ph.D.
Executive Chairman
Templeton Emerging Markets
Group
In terms of the impact of slowing growth in China, again we feel
there has been unwarranted investor panic. While China’s
equity market volatility and the government’s ineffectual attempt
to intervene directly to support prices have dominated headlines
this past summer, we remain confident that the government’s
efforts to effect a broad economic rebalancing will succeed.
While news of China’s market ups and downs makes for
splashy headlines, we expect the impact of recent declines in
mainland share indices to have limited impact on the broader
economy due to the low level of household wealth allocated to
(typically downward) in both emerging market currencies and
equities in China (less than 20%, according to our research). As
equities in advance of Fed tightening. However, during the
household exposure to local equities is very low, we believe
actual implementation of previous US rate-rising cycles, equities
there would not be a profound wealth effect even if we saw a
have been able to improve—illustrating our belief that markets
market crash in China.
tend to price in a worst-case scenario prior to the event. Looking
at the MSCI Emerging Markets Index, the average one-year
performance (in US dollars) following a Fed interest rate
increase was 12.4%.
The government is also systematically addressing the structural
weaknesses in the economy—most notably concerning debt—
with the mandated transfer of banks’ bad loans to asset
management
companies,
higher
non-performing
loan
While a series of continued and aggressive rate hikes would be
provisioning at banks, and the development of local government
bearish for emerging markets, given the first round of increases
debt markets. Furthermore, while aggregate levels of debt are
in December 2015, that scenario does not seem likely to us. US
relatively high, given China’s level of economic development,
multinational companies (and thus the broader US economy)
the country also has a uniquely vast level of state assets,
depend vastly more upon emerging market countries (most
including
foreign
exchange
reserves
and
state-owned
notably Asia) for growth than they did during previous rate rise
enterprises that provide balance. Continued rapid rises in
cycles. Hence, a greater feedback mechanism exists now,
wages and dramatic increases in the number of service jobs
whereby declines in emerging market growth and currencies
(typically in the private sector) in our view also help counter the
have a far larger direct impact upon US economic growth and,
housing slowdown and manufacturing job losses. The increased
in turn, influence the freedom of the Fed to raise rates. We also
flexibility in the renminbi represents another welcome move
must not forget that other central banks outside the United
towards financial market liberalisation.
States have been adding liquidity via Quantitative Easing (QE)
or interest rate cuts, including Europe, Japan and China.
The value of investments may go down as well as up and investors may not get back the full amount invested
How optimistic are you that these problems can be
overcome in the foreseeable future – and that investors will
return to emerging markets?
We acknowledge that 2015 – and the beginning of 2016 – has
been a challenging time for investors in emerging markets.
Nonetheless, we remain optimistic about emerging markets, as
we consider many of the factors driving recent volatility to be
temporary.
We believe it is important to remember that emerging markets
have, in general, consistently experienced stronger growth
trends than developed markets. Even with major economies
such as Russia and Brazil in recession, emerging markets’
growth in 2016 is expected to be 4.3%, more than twice the rate
of the 2.1% growth projected for developed markets. Though
investors have been concerned with China’s growth rate slowing
down (from approximately 10% in 2010 to a projected 6% in
2016), China remains one of the fastest-growing countries in the
world. Investors should also keep in mind that the size of
China’s economy has grown tremendously in US dollar terms
from that of a few years ago, when growth rates were stronger
with a smaller base.
Furthermore, the fundamentals of emerging markets have
significantly improved over the last decade. For example,
foreign currency reserves in emerging markets have steadily
risen, and emerging markets have, in general, much lower
levels of public debt in relation to Gross Domestic Product
(GDP). In spite of recent weakness, emerging markets still
make up over half of global GDP.
It is also important to note that in times of stress, financial
markets can offer the largest upside potential in the medium
term. As investors in emerging markets, our primary focus is on
the underlying business models and fundamentals of the
individual companies we invest in, more so than broader macro
views.
Are you concerned about the Chinese economy?
We don’t believe that the Chinese economy has in any way
deteriorated meaningfully in recent months. The recent turmoil
in equity markets, as we see it, is more the result of a reaction
to US Federal Reserve’s interest rate increase and uncertainties
regarding the People’s Bank of China’s (PBOC’s) foreign
exchange policy. The market has lost confidence in the Chinese
yuan, with some speculating that it may depreciate significantly
within a short period of time. We are of the opinion that the yuan
may depreciate moderately against the US dollar, adjusting the
over valuation of the yuan against other currencies. One of the
key reasons supporting this thesis is China’s healthy current
account balance and trade surplus, which is also being
supported by low commodity prices. Corporate and household
liabilities in foreign currencies are low, thus there should be
minimum knock-on effects should the yuan continue to
which
depreciate. Moreover, foreign holdings of domestic assets are
not high. It is natural to see some outflows as the Chinese
government allow “free-er” capital flow and the domestic
economy weakens, structurally, leading to some depletion in
China’s foreign reserves. However, we do not expect this
situation to be sustained over the longer term. Moreover, even
with the recent reduction, China’s reserves remain in excess of
US$3 trillion and are the largest globally.
China’s economy remains in a structural transition. Our recent
trip to some second- and third-tier cities gave us the impression
that the service sector (e.g. tourist and culture-related
industries) were growing robustly. Although we noted that
infrastructure and property investment had slowed down due to
more stringent approval process and the still high property
inventory, we believe that this could improve gradually in 2016
as financing available to local governments has improved after
the recent government debt swap and that the construction and
sale of new properties may pick up once the government is able
to destock, as planned.
Recent market corrections have provided long term investors
with an attractive investment opportunity as markets, especially
overseas Chinese stocks listed in Hong Kong, are traded at
historically low price to earnings multiples. While the yuan
depreciation may adversely impact earnings growth in US dollar
terms, it will benefit the Chinese economy by supporting China’s
exports and the overall economy. Furthermore, the lower
liquidity may also allow the PBOC to further cut interest rates
and/or reduce reserve requirement ratios for commercial banks.
In terms of sectors, we are still cautious about selective financial
stocks such as brokers and second-tier banks, which have more
direct exposure to the domestic “A” share markets. We continue
to see consumption as a good investment theme. We are also
searching for opportunities in sectors where consolidation is
leading to healthier industry dynamics.
How concerned are you about the risk of contagion effect
from China, and the impact volatility may have on other
Asian markets?
We are not concerned about the risk of contagion from China on
other Asian markets because that volatility is already discounted
by the market to a great extent. The fact that China’s economic
growth rate is decelerating is already well-known. The fact that
there has been very high volatility in China’s stock market is
also well-known. These factors have already had an impact on
markets worldwide including that of Asia and the US. However,
there are many other factors impacting markets worldwide,
including the interest rate picture in the US. Of course, actions
by the regulatory authorities in China to restrict selling have
created even more uncertainty which is probably the most
important factor we should consider.
Emerging Markets Monthly Commentary
2
What do you think will be the biggest potential challenge
for markets in 2016?
The biggest potential challenge has to do with confidence. With
the volatility experienced in recent years, particularly in
emerging markets, investors are fearful and thus are reluctant
to invest, seeking solace and presumed safety in US dollar
cash. Often emerging markets bear the brunt of this “flight to
safety” on these occasions. While heightened market volatility
can be unsettling, we aim to look beyond the short term to find
and invest in well-managed growth leaders at what we believe
are attractive valuations. As we look forward, it is important to
note that times of stress in financial markets can offer the
largest upside potential in the medium term. At the end of
January, emerging markets appeared undervalued versus
developed markets, based on price-to-earnings and price-to-
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