Probability-based investment modelling for professional and institutional investors
All EM equity indices comprise a mix of countries which once shared some important economic characteristics, but no longer do. The whole asset class is dominated by China, where the investment outlook is increasingly uncertain. Looking at over 20 different countries with vastly different growth profiles and levels of income no longer makes sense. Investors who wish to reduce the complexity of their portfolios should think about swapping their EM equity allocation for one to India on its own. It has outperformed its benchmark by a substantial margin over the last 5,10, and 20 years and will probably continue to do so given its superior demographic profile and productivity outlook.
EM Equities are in deep trouble and we see no early turning-point, mainly because China is also suffering. The strong outperformance promised after the end of lockdown has not materialised, but more importantly, our models suggest that the local equity market itself is not functioning as it should. Two relatively obscure indicators: active weight and persistence of winning and losing sectors are either at, or very close to, 20-year lows. This suggests that investors are struggling to construct portfolios, which deliver an appropriate balance between risk and return. This is not a problem China has suffered from until recently and if it continues, international investors may have to regard this as a secular trend, not a cyclical aberration. If EM and China are not attractive destinations for international capital, other regions must benefit on a relative basis – and the most obvious is Europe.
We agree with the idea that US equities are going to suffer in the New Year, but disagree with many of the assumptions surrounding this view. We think US Treasuries are behaving like a risk-asset and cite their current elevated volatility as evidence. We highlight the positive correlation between equities and bonds, which means that there we may well repeat the bear market of everything we saw in H1 2022. On this basis, the dollar strengthens temporarily and the trough in equities is delayed till Q3. When the recovery comes, sectoral and geographic leadership in equities in likely to change and China will be a much bigger part of the story than Western investors currently imagine. The outlook for oil is anyone’s guess, but it will influence inflation expectations and generate bursts of volatility in all markets, contrary to its current benign behaviour.
We spend a lot of our time dissuading clients from going bottom-fishing, mainly because it doesn’t work very well. But there are times when we may need to do it to protect ourselves from the risk of being underweight a sector or country which rallies very fast. This week we highlight a combination of charts (EM Equities and China vs the World and Chinese Technology vs China) which have all sent recent signals suggesting that we may need to close our underweight positions in a hurry. There is a risk/opportunity that Chinese Technology could lead sharp and unexpected rally in EM Equities.
We expect global equities to start rotating faster than usual on a country/regional basis. We discuss the technical rationale in some detail, but the important message is that this not about the recent winners such as the US and India, or the losers like China and Korea, but all the others, which are somewhere in the middle. There are several European countries like Germany, the Netherlands and Sweden, which are at risk of dropping down the ranking, while selected EM countries in Asia and Latin America could benefit. If our analysis is correct, this should happen before Christmas.
Our recommended exposure to Chinese equities is effectively zero, but EM Equities (of which China is by far the largest part) are critical to the success of any global balanced portfolio. So, we have looked at individual Chinese sectors to see which ones have been the most successful diversifiers compared to their US counterpart. The good news is that it is easy to identify those which fail the test badly: Financials, Industrials, Telecom and Small Caps. The bad news is that only Technology has offered successful diversification over the whole of our test period, but now is not a good entry point. There may also be opportunities in Consumer Staples and Healthcare, but, again, we prefer to wait for a better entry point.
We think it is time to take China out of the main EM equity indices. Some of the arguments made for its inclusion are no longer valid. It doesn’t make sense to have separate benchmarks for companies listed in China and Hong Kong. Separate indices for China plus Hong Kong and the rest of Emerging Markets would increase flexibility for all investors, not just those who no longer wish to have passive exposure to the current regime in China. Once we make the split, we can see that EM ex China has already begun an interesting rally.
Our recommended weight for Chinese equities has just hit its all-time low since the beginning of this century. They have been in extreme underweight territory for their longest period ever. We think this is more than a temporary misunderstanding. It could represent the breakdown of the pro-China consensus that has dominated US investment thinking for over a decade. There may be parallels with what happened when the US became disillusioned with Russia 10 years ago. US investors who want international equity diversification will be forced to have another look at Europe.
Everyone is suddenly on bubble alert, but our numbers suggest that the main danger lies in Asian equities, not the US. China, Hong Kong, Taiwan, Korea, India, Japan, Australia and Indonesia all have weekly RSIs above 70%, which is our warning signal. US equities are still below this threshold, apart from Small Caps, which broke above it three weeks ago.