Market Review
The benchmark MSCI China index declined -9.1% in Euros during the first quarter of the calendar year.
We had observed an improving macroeconomic data picture across Asia in January, and if it wasn’t for Covid-19, we would be looking at very different performance data now. In fact, many companies in particular in China reported a constructive Q4 and early January operating data.
We are seeing indiscriminate selling across asset classes, not only equities. Asian credit markets are pricing high yield bonds at a significant risk premium to developed market peers of the same rating class. Around half of the issuer universe is represented by Chinese property developers.
Curiously, within Asian equities, China – the likely origin and epicentre of Covid-19 – was a surprise outperformer due to the strong domestic support for A-shares on the Shanghai and Shenzhen exchanges, and through the southbound connect into the Hang Seng’s market segment of China mainland companies.
Performance Review
While we are disappointed to see negative absolute performance, we are pleased with the outperformance both for the quarter and the running financial year.
Backward-looking earnings estimates have become somewhat meaningless. Even though many companies reported strong earnings, their share prices declined due to the uncertain outlook associated with Covid-19. For example, Dream International, a Hong Kong-listed toy manufacturer, announced a more than 40% rise in its 2019 earnings, and yet the stock is down -16% year-to-date, trading at 4x earnings.
It is important to understand that it’s not the virus itself that is hurting the economy, it is global governments’ and business’ containment policy (to protect human life, social cohesion and health care system capacity) that lead to reduced activity and an unprecedented sudden stop to economic activity, providing a simultaneous supply and demand shock. This is remarkedly different from prior such case studies like SARS.
Outlook and Strategy
China is stabilizing its current account into surplus with tourism shut off and oil down. Last year a c. 3% of GDP positive goods balance was counteracted by a negative -2% from services (tourism including some hidden money flight). With a sudden halt in tourism, presumably for a good part of this year, the current account is currently as high as 2010. This is likely why the Renminbi hasn't sold off heavily, and Chinese bonds have been a counterintuitive safe high interest haven. Dry bulk shippers are telling us their China business is doing well right now, suggesting a significant inventory build-up in e.g. steel as construction in China remains low, while industrial plants run at full capacity again. This inventory build-up could clear soon however, as property companies have opened their sales offices again and volumes have already gone back to around 70% of prior year sales in March. We are hearing similar levels for most other activity indices in China, and social media accounts show significant improvements in daily life.
At some point Covid-19 will be history, but there are already signs what its long-lasting legacy will be. In the West, quantitative easing, yield curve control, modern monetary theory (MMT), maybe even universal basic income and euro-bonds. For Asia, the future of the globalization and the global supply chain is the key question. Outside of select geostrategic considerations (e.g. self-reliance in certain pharmaceutical goods), supply chains will primarily shorten and diversify, according to a survey of more than 3,000 companies by BofA. Just as was the case with the trade war, the long-term case for Southeast Asia remains intact in such a scenario. Supply diversification will also necessitate regional intensification i.e. instead of combining a China and Vietnam component, manufacturers will deepen their Vietnam cluster to a full chain to create more redundancy in the system, alongside China. Existing and attractive FDI hubs will thus benefit from this intensification, and this will counterintuitively also mean a continued strong China presence. Vietnam, Thailand, and Malaysia should do well out of this. More marginal hubs (e.g. Laos) may lose out to reshoring to the US (incl. probably Mexico). All in, we would expect to see excess capacity build up in global manufacturing, as just-in-time gives way for some intended slack. Returns on capital across the world would fall.
Over the past two decades, global investors have become accustomed to the S&P500 ETF being the consensus long investment, and indeed the outperformance has been tremendous. It is well known that through share buybacks corporates were by far the biggest source of demand (about $500bn p.a.) for equities in the US, driving up share prices while flattering price-to-earnings-per-share valuations. This driver will be materially absent in the near term, opening the window for other parts of the world to shine.
Florian Weidinger, Hansabay