Cast the net for recovery profits

Western democracy is hardly in rude health, so virtue signalling smacks of rank hypocrisy. Nevertheless, in the same week America’s presidential election plumbed the depths, there was a reminder of drawbacks in store when authoritarian China becomes the world’s leading economic power.

Ant Group’s $37bn initial public offering was pulled from the Hong Kong and Shanghai stock exchanges ostensibly on regulatory concerns, but it’s hard to shake suspicion the communist party simply got cold feet. Ant runs Alipay, China’s leading mobile payments service, and when co-founder Jack Ma made noises about regulators and ambitious plans for his company’s role in China’s financial system, the government flexed its might.

Despite the hiccup, China is poised to take a bigger role in capital markets

Once Mr Ma is slapped back into line, it should only be a matter of time before Ant lists. Prior to the debacle, overseas investors had started to flock to Chinese assets, with strong appetite for dollar-denominated issues of Chinese government debt and currency markets seeing steady demand for the renminbi.

In terms of equity markets, China’s A-shares (those listed on the mainland exchanges in Shanghai and Shenzen) are now included in major emerging market indices. But, as the Ant episode reminds us, often all is not as it seems. If one of China’s most prominent businessmen can misjudge the ruling elite, it is unrealistic to expect western fund managers to make all the right calls, but investors should still prize expert knowledge.

Several UK-listed investment trusts have done well this year from their holdings in Chinese technology companies, which are world-class innovators and even lead their US counterparts in areas such as mobile payments and e-commerce.  

Shares in Alibaba (HK:9988), the e-commerce giant Alipay was first spun out of (and which has a sizeable stake in Ant), fell on the news of the IPO being withdrawn, but this is a company setting standards in video experiential shopping. The other big name in payments is Tencent (HK:0700), owner of the WeChat social media service, a pioneer enabling purchases within its messaging app.

By 2022, there will be around 3bn internet users in emerging markets, three times the number in developed economies. Austin Forey, manager of JP Morgan Emerging Markets (JMG), emphasises the trend towards capital-light businesses which have been excellent at creating shareholder value such as social networks, ecommerce and software businesses: “We strongly believe that growth in this sector is likely to continue to accelerate over the years.”  

Navigating regulatory and cultural differences is worth it, given the size of the opportunity, but there will be more bumps in the road. Valuations of some of the larger Chinese companies need to be watched closely, too, especially A-shares. Furthermore, despite restrictions on inexperienced individuals buying into IPOs, China’s secondary capital markets are subject to volatility caused by Chinese ‘mom and pop’ investors rushing in and out of stocks.

Managers also have geopolitical issues to contend with. The tug o’ war over tech is central to China’s rivalry with the US. This has been material, not only for growth prospects in both countries, but also for companies in third-party jurisdictions. For instance, the ban on semi-conductor materials being exported to China from the US and Taiwan is causing headaches for Chinese companies, as these products represent a technological blind spot. Taiwan is as contentious as it gets – China doesn’t recognise its sovereignty – although leading companies such as Taiwan Semiconductor (US:TSM) are important holdings for several funds.

Asia Pacific’s pandemic response puts Europe and the Americas to shame

Ingredients for volatility in Asia Pacific stocks are plentiful, but that means potential for upside as well as downside and the important positive factor is growth. While Europe plays lockdown whack-a-mole, economies on the other side of the world are on a much firmer footing to resume expansion.

Populous nations with large urban conurbations such as Thailand, Singapore and South Korea have impressively curtailed their-epidemics so far. Malaysia has seen an uptick in cases in recent weeks, but the curve is levelling off and its seven-day rolling average case rate is still a fraction of the UK’s.

Stock markets in what were previously dubbed Asia’s tiger economies aren’t expensive. Data from German asset management firm Star Capital rates countries on a variety of valuation measures and produces an overall composite value score. Their ratings of the 40 cheapest global markets at the end of October had South Korea as the best value in the world. Singapore was fifth and the Philippines was ninth. China, which is too big to count as one of the tigers (it’s more of a dragon), was second on the list.

China’s cheap rating is partly down to the MSCI China benchmark used being a blend of listings. The index includes Hong Kong H-shares and American depositary receipts (ADRs), neither of which are as frothy as A-shares’ valuation.  

Caution also needs to be exercised applying traditional value criteria such as the price to book value ratio. Many companies with a high proportion of tangible assets on their books are vulnerable to impairments. This is one of the reasons Robin Parbrook, co-manager of Schroder Asian Total Return (ATR), prefers businesses in technological industries where intangibles such as intellectual property, brand and patents drive the potential for future earnings.

Active stock selection takes account of ESG risk factors

Environmental, social and governance (ESG) considerations are essential due diligence when investing in emerging markets. In China, the communist party has the last word, but governance in terms of capital structure (especially how much debt companies carry) and management are variables a manager can assess.

The social aspect is also of concern, with western investors uneasy at crackdowns on Hong Kong protesters and reported abuse of China’s Uighur Muslim minority. Although if large western-listed companies such as banking giant HSBC (HSBA) can be coerced into tacitly being an apologist for the Chinese government, then mainland domestic-focused businesses have no chance. Still, there is at least scope for discernment with active funds.

Environmental challenges are already material for investment decisions in emerging markets, with the risks a serious constraint for companies’ operational growth, never mind any added pressure from asset owners. Problems are most acute in India, where energy infrastructure, sanitation, food and water security might override the potential offered by a young population and a rapidly expanding middle class.

A lot of structural issues in India may hold back growth, says Mr Parbrook, who identifies headwinds from its vulnerability to climate change and the potential of robotics to nullify the comparative advantage in labour.

Unlike its east Asian counterparts, India has mirrored the abject performance of western governments in the pandemic, with one of the highest death tolls worldwide. Some of the consumer stocks in India-focused funds such as Hindustan Unilever have performed well on the back of demand for sanitisation and hygiene products, but other growth themes have been stymied.

Is the outlook brighter in a post-Trump world?

Although the US elections only gave him a thin mandate, president-elect Biden will seek to roll back much of his predecessor’s ‘America First’ agenda in foreign policy. Reaffirmed US commitment to fighting climate change is positive for emerging economies, but as the direct costs of global heating become increasingly apparent, they will still have to invest heavily themselves to help curtail it. 

The outlook for trade with the US is improved with Mr Biden as president. The Trump administration pulled off quite a success in renegotiating some trade agreements (noticeably Nafta with Mexico and Canada), but it’s unlikely Mr Biden will go after any more friendly nations for better terms.

China is considered more rival than friend, so although the language from Mr Biden will be less inflammatory, America won’t fully reverse its tougher line on Beijing. The relationship between the world’s two biggest economies is also crucial in shaping the outlook for developing nations. Many countries benefit from investment under China’s Belt and Road initiative and the US dollar’s status as global reserve currency means, in a sense, that there is a face-off between fiscal and monetary brands of neo-imperialism.

Dollar decline provides another fascinating sub-plot

Developing nations, and their companies, raise money on global capital markets by issuing US-dollar-denominated bonds. This enables them to borrow in a hard currency, but it also entails vulnerability to the US dollar exchange rate. The United States Federal Reserve’s massive quantitative easing (QE) programme and slashing of interest rates has pushed down the value of the dollar against other currencies, which is good for emerging market borrowing costs.

America’s long-term economic decline, and its enormous debts, could place the dollar’s exalted status in jeopardy. This narrative needs to be tempered by the fact investors still flock to US Treasury bonds as a haven asset and the dollar is also integral to international companies’ funding needs for the medium term.

Alternatives to the dollar are emerging. Use of gold as part of a more multilateral reserve system has been touted by countries such as Russia, which as a commodity-led economy is constrained by the fact its main outputs are priced in dollars. Cryptocurrencies are still mistrusted by governments and central banks, but their evolution continues.

Perhaps the rise of China’s renminbi is most interesting. Meaning ‘people’s money’ renminbi is the medium of exchange, although yuan is the term used for referring to units of the currency. In contrast with the West, China’s economy is beginning to purr again, so demand for renminbi has been strengthening.

It’s not just recovering exports that are supportive. China’s slow liberalisation of its capital markets enables investors from around the world to take advantage of a new opportunity set of securities. That includes bonds and equities, although the communist party may be even more jumpy about foreign investors getting involved in debt markets than they are about shares.

That said, in a world full of uncertainty, political risk exists and is growing for European and American shares, too. China’s capricious ruling party is more than just another fly in the ointment, but investors need to go for growth where they can get it. Balancing portfolio risk across asset classes and regions is crucial and emerging market funds, especially those focused on Asia, will only grow in importance.