Similar to European equity markets, another part of the world where fearful perceptions have held back equity valuations is emerging markets. After being fairly range-bound from 2012 to mid-2015, fears of a hard landing for China’s economy impacted emerging markets in the second half of 2015 and early 2016. That can be seen in the first chart showing the MSCI Emerging Markets Index. Weakness in global trade volumes also hurt emerging markets during that period.
As things turned out, China’s economy proved to be more resilient than many had feared and emerging markets rallied through most of 2016, as did commodity prices and resources stocks, with some volatility around the time of the US election.
Nevertheless, concerns about trade protectionism, given some of the views expressed by President Trump, persist. Most emerging markets are highly export-dependent and any restrictions on international trade would be a clear negative. However, one could argue that much of that fear is already priced in and may be overdone.
The second chart shows the 10-year valuation bands for the MSCI Emerging Markets Index. The 12-month forward PE ratio of 12.1x is only slightly above the 10-year average. The forward Price/Operating Cash Flow multiple of 7.0x is right on average, and the Free Cash Flow Yield of 7.6% is above average.
On Friday President Trump reached out to his Chinese counterpart, Xi Jinping, and reaffirmed the US’s long-standing support for the “One China” policy during their first telephone call. President Trump’s earlier comment that a “phenomenal” plan to overhaul business taxes may be released within the next “two or three weeks” also helped Asian markets rally on Friday. So did the latest China trade data for January, which showed stronger-than-expected growth in Chinese exports (15.9% YoY) and imports (25.2% YoY), both measured in CNY terms. The MSCI Asia Pacific Index, which includes Japan, rose to the highest level since July 2015 on Friday.
The largest country weights in the MSCI Emerging Markets Index are China (25.7%), South Korea (14.4%), Taiwan (12.1%), India (8.2%) and Brazil (7.7%). The four biggest individual stock holdings in the index are Samsung Electronics, Tencent Holdings, Taiwan Semiconductor and Alibaba Group.
Given China’s weight in the index, what is happening inside China at the moment is having a significant impact. Cheap Hong Kong equities are suddenly back in vogue with Chinese investors. As tightening capital controls in China turn HK’s stock market into one of the few Beijing-approved destinations for offshore investment, mainland traders are piling into shares that have long been priced at much lower levels than their counterparts in China. Average daily inflows through HK’s exchange links swelled to the highest level this month since September, while the city’s Hang Seng China Enterprises Index was the best performer among major world equity indices last week.
The influx of mainland money has helped narrow valuation gaps between the markets, which persisted for more than two years despite growing cross-border connections. Even so, dual-listed stocks remain about 33% cheaper on average in HK. The discount may narrow further as HK remains a good choice for Chinese investors who seek exposure to overseas assets but face challenges bringing money out of the country. As a high-profile part of President Xi Jinping’s pledge to integrate China’s financial markets with the world, the links have been left out of a sweeping government campaign to clamp down on capital outflows and prop up the yuan.
While mainland investors using the stock connect program have to be repaid in yuan when they sell HK shares, they are shielded from any depreciation of the Chinese currency while their money is on the other side of the border. Inflows into the city have propelled the Hang Seng China index of so-called H Shares to a 5% rally since 3 February. The Hang Seng China index exceeded the value of its constituents’ net assets last week, after trading at a discount of as much as 26% last year.
Protectionism could still rear its ugly head and spoil the emerging markets rally but, for now, investors think they are beginning to see light at the end of the tunnel and that perhaps Donald Trump’s bark is worse than his bite.
An insightful commentary