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Strategy Commentaries

Global Emerging Markets Equity Strategy Commentary

June 30, 2022

Growing consensus that central banks are serious about reducing inflation, even at the expense of tipping economies into recession, caps off one of the poorest performances on record for world stock markets in the first half of a year. Emerging market equities outperformed developed markets over the quarter.

In an environment of tightening global liquidity and weakening global growth, EM equities typically face the most severe hangover. In contrast to previous cycles, however, many emerging markets entered this downturn with lower leverage (most EM central banks did not carry out pandemic QE), low inflation, proactive central banks willing to use interest rates aggressively to curb inflation, and valuations at extreme lows versus DM.

China typifies the positive EM divergence in terms of real money growth and fiscal / monetary discipline. Having run tight policy throughout the pandemic, inflation today is low, while equities endured a torrid selloff over the past 12 months on fears over regulatory overreach, geopolitical risk, and Beijing’s pursuit of Covid-zero. This was followed by a flood of initiatives fronted by Xi Jinping and CCP Standing Committee members supporting the economy and reassuring investors that crackdowns on key sectors would ease and economic growth would be prioritised. In June, Xi reiterated the commitment to achieving 5% GDP growth in 2022, implying 7% growth in H2. To achieve this Beijing will need to escalate efforts to revive the economy, and the data towards the end of Q2 confirmed improvement in money growth and PMIs recovering.

The 20th National Congress of the CCP in the fall approaches, where it is expected that President Xi will secure a norm-breaking third term. To be sure, the CCP wants to ensure a brighter backdrop than in H1 for Congress. The promise of a domestically produced mRNA vaccine slated for approval in Q3 would be a major boost, likely allowing the government to abandon reliance on crushing lockdowns at the first sign of an outbreak.

These events underpinned a steady shift up to a neutral weight through Q2, having been previously been underweight for close to 18 months prior to this. The approach has been to favour higher quality companies as another Covid outbreak could crush sentiment. The stocks of China’s tech megacaps have been flattened over the past year but now these high quality and growing businesses are running into easy comps, easing regulatory headwinds and a steadily recovering economy.

In addition to the established names in China, negative sentiment for Chinese equities represents an opportunity to gain exposure to future structural winners at compelling prices. For example, the EV industry has massive growth potential through share gains from internal combustion engines (ICEs) and rising car budgets of China’s middle class. Rising fuel prices, policy incentives, higher battery density and range, improving charging infrastructure and unit pricing approaching parity with ICEs are all tailwinds for EV adoption. Leaders within the sector such as NIO and XPENG possess powerful brands within their niches, preferred by Chinese consumers over Tesla and premium German OEMs. By launching new models and delivering more units, as well as selling ancillary services such as battery swapping, operating profits can soar as NIO and XPENG scale up.

Earlier in the year we flagged the short term risk to Indian equities on deteriorating liquidity conditions. Our response was to reduce our overweight through paring back cyclical exposure. While Indian equities will face headwinds in the short run, there are a number of attractive structural investment opportunities that will play out over the long term. One of the biggest opportunities is in the housing sector. Multiple structural tailwinds drive growth in housing including rapid urbanisation and mortgage penetration of only 11% which leaves headroom for growth (versus 18% in China, 20% for Thailand and 34% for Malaysia). Housing affordability is high for a young and rising Indian middle class. This should all spur demand for housing in India over the long run.

Our liquidity analysis points to global GDP contraction through H2 and peaking G7 inflation as commodity price pressures and pandemic distortions ease. In this environment we continued to tilt the portfolio to a more defensive footing, along with trimming winners and more cyclical names as a source of cash to increase China exposure. This assessment was central to our decision not to chase the commodities rally, with the fund underweight countries with high exposure to commodities and energy such as Brazil, South Africa and GCC, which was a sigifnicnat contributor to performance. Stock picking within the materials sector also added value, particularly from lithium names in the portfolio which benefit from a global boom in demand for batteries. Exposure to China was the largest detractor, as while we closed the underweight over the period, it did not completely capture such a sharp rise in Chinese stocks as sentiment bottomed. We are happy to move cautiously and examine the data to assess whether a sustained recovery is beginning to take hold, and adjust the portfolio accordingly.

Looking forward, hawkish policy actions by central banks may be seen as an unnecessary misstep. Our two measures of global excess money were negative in H1 consistent with the market weakness year to date. Normally quality stocks perform well when there is a double negative reading but the factor has an inverse correlation with bond yields. We expect the normal relationship of yields with falling global PMIs to be re-established during the second half with lower yields driving better performance from quality stocks. Emerging markets have shown some relative resilience and the YTD fall in prices offers investors the opportunity to gain exposure to high quality companies at compelling valuations, particularly in China which appears to be in the early stages of a rebound.

The Composite fell 10.62% (10.82% Net) versus an 11.45% fall for the benchmark.