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8th October | Dubai
By Peter Garnry, Head of Quantitative Strategies, Saxo Bank
The energy sector is not out of the woods as we enter the fourth quarter, and we recommend that investors underweight Brazil. On a longer-term horizon, the opening of China’s capital markets offers tremendous opportunities, and the impact is likely to be as significant to investors as the end of the Cold War.
“Any investor who is underweight China and India over the next 50 years will greatly underperform global equity indices.”
“The leading Chinese technology companies that should be part of anyone’s portfolio are social media and gaming company Tencent, ecommerce giant Alibaba and search engine group Baidu.”
“The world’s next 1989 moment”
In our third-quarter outlook, we asked whether equities were immune to a slowdown. Despite mixed signals from China, with its leading indicators declining since March, global equities continued to climb to record levels. Global equities rose 3% in Q3 in local currency terms. This fourth-quarter outlook focuses on the ongoing equity rally and its threats. We will also focus on China and the prospects of the country opening up its capital markets.
Is the Brazilian fiesta ending?
While developed-market equities rose 3% in local currency, emerging-market stocks were the big winners, gaining almost 10% in local currency, with Brazilian equities taking the lead, up impressively 20% in BRL. The main driver of EM performance was another 4% decline in the US dollar against other currencies. A weaker USD eases financial conditions globally, thereby boosting EM countries with extensive borrowing in USD.
The political crisis engulfing Brazil’s president continues to escalate, but without any significant impact on the currency. The local equity market has extended its rally as the macroeconomic outlook has improved further, with unemployment now firmly ticking down again. Valuation metrics have been pushed to levels competing with US equity markets, which in our view seems stretched given the political situation and potential slowdown in the short-term business cycle driven by China as credit growth slows. Seen in that light, we recommend that investors underweight Brazil going into Q4.
Energy sector not out of the woods
Looking across the sector landscape, energy was the third best performer in Q3, delivering almost 5% in local currency against a backdrop of rising oil prices. The rally was driven by a combination of factors ranging from the weaker USD and Hurricane Harvey hitting US oil supply, which caused sentiment towards oil prices to rise. However, current price levels are stretched against global supply-and-demand forces, and it’s our view that oil has limited upside from here, which we cover in full detail in our Q4 commodity outlook. As a result, we maintain our negative view on the energy sector.
The world’s next 1989 moment
While the world is fixated on a perceived upswing in terrorism and destabilisation on the Korean peninsula, China is moving forward to opening up its economy in a longer-term plan to overtake the US as the world’s leading superpower. The impact will be as significant to investors as the end of the Cold War in 1989, which was succeeded by a rapid increase in global trade volume as new markets were included in the World Trade Organization.
China’s latest moves in opening up its capital markets include the so-called Bond Connect that allows foreign fund managers to trade in China’s $9 trillion debt market without setting up an onshore account. The so-called Stock Connect is already integrating Hong Kong, Shanghai and Shenzhen, and likely paved the way for MSCI’s decision to add 222 China A large-cap stocks in its MSCI Emerging Market Index and increase China’s weight further from current levels at 29%. In addition, China was included in the International Monetary Fund’s special drawing rights basket, making the renminbi part of global reserve currencies. China has also opened up the fund industry by allowing foreign fund management firms to own 100% of local fund businesses, causing money managers, such as Man Group, Bridgewater Associates and Fidelity International, to start private funds in China. Moreover, Chinese regulators are moving forward to allow foreign insurance companies to provide health, pension and catastrophe insurance.
The People’s Bank of China is expected to propose regulation later this year to allow foreign institutions to control their local finance-sector joint ventures as well as raising the current 25% ceiling on foreign ownership in Chinese banks. The rationale is that if China does not open up its economy, it will be lazy and uncompetitive in the future.
We highlighted in a recent research note that based on China’s 56% urbanisation rate, corresponding to where the US was in 1930, China has many decades of above-average growth rate ahead of it. As Chinese capital markets are opened, global investors will be able to participate in what will be the most transformational century as China and also India will regain their former glory in terms of global wealth share. China is already the largest economy on a purchasing power parity-adjusted basis. Any investor who is underweight China and India over the next 50 years will greatly underperform global equity indices.
For investors in the developed world we recommend overweighting the technology sector as it remains the least regulated and overwhelmingly private sector. Buying broad-based indices through exchange-traded funds will still be a good approach for most, but the overweight of state-owned companies will be a drag on performance during the transition to a high-technology and consumer-driven economy.
China already leads in many fields
China’s State Council AI Development Plan, announced in July 2017, sets clear policy goals on artificial intelligence, aiming for China to be the global leader in all AI and robotics-related industries by 2030. The plan is a direct response to the rising wages that are lowering China’s competitiveness. National wages are up 200% since 2006, or 13% annualised, which is unsustainable in the long run. As result, Chinese manufacturers are already heavily investing in robotics and automation technologies. Global data also suggest that robot density per 1,000 workers is positively associated with higher corporate profitability.
Very few publicly-listed Chinese companies operate in the robotics industry. According to our research, only four exist, and they all trade on mainland China exchanges, making it difficult to get access. The biggest publicly-traded robotics firm is Estun Automation with a market value of $1.9 billion. If the stock is one of the A shares included in the EM index in 2018, global investors will get a slice of China’s robotics future.
The leading Chinese technology companies that should be part of anyone’s portfolio are social media and gaming company Tencent (00700:xhkg), ecommerce giant Alibaba (BABA:xnys) and search engine group Baidu (BIDU:xnas). These three companies have had combined revenue of $64.8bn in the past 12 months, up 26.4% year-on-year. They all have leading positions in their respective industries and are all hugely profitable.
Within the consumer staples sector, investors can find tomorrow’s consumer winners in China. The largest beverages company Kweichow Moutai has a market value just below $100bn and is growing at 23% annually, which is a pace no beverages company in the developed world will ever come near.
In the healthcare sector, one of the largest publicly-listed companies is CSPC Pharmaceutical (01093:xhkg), with $1.7bn in revenue and growing at 14% annualised and with a market value around $10bn. It is one of China’s leading specialty pharma companies.