Investment Strategy
by Larry Adam

Weekly Headings

April 22, 2019

While the MSCI China Index has been the best performing country index year-to-date (YTD) (+23%), concerns that the rally in emerging market (EM) equities may be over is premature. First, YTD, broader EM (+14.0%) and Asia EM (+15.3%) have underperformed the S&P 500 (+16.4%)*. Second, over the last year, China, EM Asia, and EM broadly have underperformed the S&P 500 by 10%, 11% and 13%, respectively. As a result, there still appears to be some catch-up ability on behalf of EM equities. Emerging markets, particularly in Asia, remain one of our favored regions for several reasons including:

  1. Improving Macro Environment | With the U.S. economy growing above trend, the environment for risk assets should remain healthy. U.S. growth is important to China as the U.S. accounts for ~19% of China’s exports, outpacing exports to Europe (~17%) and the rest of the emerging Asian economies (~13%). In addition, China’s growth appears to be stabilizing from coordinated fiscal and monetary policy stimulus. The implementation of an April Value Added Tax (VAT) cut lowered the VAT in manufacturing from 16% to 13% and in transportation and construction from 10% to 9%. Monetarily, the People’s Bank of China (PBoC) is expected to cut the reserve requirements for banks three additional times this year, adding more capital creation to the system. This week’s better-than-expected 1Q19 GDP (+6.4%), retail sales, and industrial production figures suggest that these policy moves are gaining traction.
  2. Stabilization of the U.S. Dollar | EM currencies, in aggregate, have rebounded ~4.5% from their September 2018 lows but remain 4.5% from their record highs. With the Federal Reserve (Fed) likely on hold for the rest of the year, inflation remaining muted globally, and EM economies showing signs of improvement, EM currencies should slowly grind higher. Stable or appreciating currencies are a positive for EM equities as they have strong positive correlation.
  3. Budding Fund Flows | Starting this month, China's yuan-denominated bonds are being added to the Bloomberg Barclays Global Aggregate Index. As a result, a total of 356 government and policy bank bonds (~$3.3 trillion) will be added to the index over the next 20 months, taking the exposure of Chinese bonds up to ~6% of the index after full inclusion. Similarly, major equity indices like MSCI and FTSE are increasing their weighting to Chinese equities significantly this year. Increased weightings in both fixed income and equity indices will drive cash flows into the Chinese markets, especially from passive index investors.
  4. Favorable Sector Composition | The three largest sectors within the MSCI EM Index should benefit from our expectations. Tech, our favorite global sector, represents more than 25% of the index. Financials should benefit from the lowering of required reserves and potentially lower interest rates. Consumer discretionary should benefit from the wealth creation driven by the expanding middle class.
  5. Trade Truce | We believe the U.S. and China will complete a trade deal in the next few weeks. Treasury Secretary Mnuchin remains optimistic, U.S. Trade Representative Lighthizer is under pressure to get a deal done, and President Trump is in re-election mode and wants no further trade-induced harm to the U.S. economy (or the equity markets). Final issues to resolve revolve around existing tariffs (whether the recent tariffs will get reversed), enforcement of the deal including intellectual property, and China’s currency management.


U.S. Equities
Fixed Income

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