Market thinking

Is India the next battleground for China v US?

  • A combination of attractive valuation and an end to distressed selling has helped markets recover in the first six weeks of the year. The absence of speculative froth is also a positive.
  • The prospect of a settlement to the broader Trade War is helping sentiment across Asia, but the Economic Cold War between the US and China is here to stay. Back to basics of strong balance sheets and good cash flows is the best downside protection in this environment.
  • As China breaks away from BRICS, and Asia from Emerging Markets, India could be the next battleground for China v US corporate competition.

Asian markets have begun the year positively as the distressed selling towards the end of Q4 ceased to be a headwind and the attractive valuations were seen to compensate for the known risks around trade war that continue to dominate the headlines. Flows have been strong, especially into China and Taiwan as international investors get to grips with ‘needing’ exposure to Asia in general, and China in particular. We also continue to believe that the additional headwind experienced in 2018 of a stronger dollar will be much less of a factor this year while at least one part of the trade war – the conventional spat over tariffs -will see some resolution in the coming weeks, helping to further reduce risk premium.

The dramatic rally in US Treasuries and sell off in US Equities during the fourth quarter was not unprecedented, but when we see such moves we always find that they were little or nothing to do with economics and almost always to do with (bad) market positioning. The fact that Vix spiked to 36 on Christmas eve was testament to the end of year disruption, as was the strength of 3 month Libor, which saw its now traditional year-end squeeze to leave it at 2.8%. Both have now dropped back, Libor to 2.7% and Vix to 15.65, below its long term moving average, making for a calmer technical background for all markets. The S&P500 has recovered around 2/3rd of its sell off to be back above its long term moving average, but bond yields remain in a 2.6-2.7% range, leaving the US yield curve essentially flat. However, as we noted before, the yield curve is not telling us very much about the economy, rather it is telling us how incredibly difficult it is to make money from carry trades in the US.

This rotation and mean reversion is something that came up frequently during the two large Chief Economist Forum presentations in Melbourne and SydneyI attended. As part of my opening remarks I referred to the following slide, based on the conventional views on markets at the previous two forums.

Chart 1: Mr Market loves what he hates and hates what he loves.

As can be seen, all the markets that conventional wisdom ‘hated’ in early 2017 were the best performers over the following 12 months, leading them mostly to become the most ‘loved’ markets in early 2018, whereupon they largely underperformed! If we look over a two-year period overall most things are broadly flat. It means however that the ‘love/hate’ relationship began this year looking more like early 2017, with the result that after a year when everything was down (except cash) we now see that almost everything is up.

Of course, this time last year we had two further ‘love interests’ for markets, the XIV ETF (an inverse of the VIX volatility index) and Bitcoin. The first had been a phenomenal momentum trade during 2016 and 2017, rising from 0.15 to 1.10, creating some worrying financial market distortions along the way as market makers were effectively selling volatility to service the inflows, creating an imbalance that blew up spectacularly in February last year and the ETF is now effectively liquidated. Meanwhile Bitcoin (as measured by GBTC, the bitcoin ETF) collapsed around 85% during the year. Both were signs of leverage and speculative froth in markets, neither of which are evident this year, which should serve as a source of some comfort to back up the more comfortable valuations.

The prospect of a settlement to the conventional elements of the trade war is also helping sentiment. As we discussed previously , it is in everybody’s interest to settle the tariff issue as firstly the next round of tariffs will hit US imports of intermediate and final goods where there really is no alternative and thus will either squeeze US manufacturers or US consumers, or both. Second, as the map from my colleagues in AXA IM Research illustrates, much of the origination of the value added in Chinese exports comes from elsewhere, so hitting ‘China’ is actually hitting a lot of other countries.

Chart 2: The threat to the global supply chain needs to be averted if possible.

Source: AXA IM Research November 2018

As previously discussed, there is a lot of coincidence of self-interest here. China is happy to buy commodities such as Soya and LNG from the US and it is equally happy to encourage competition in areas such as autos and financial services, where observation of other North Asia mercantilist economies such as Japan and Korea has revealed that allowing large domestic quasi-monopolies to evolve is not necessarily a good thing for consumers. This would all appeal to President Trump and especially his ‘base’. Equally a lot of America’s strategic allies, especially ones in Asia that it wishes to court such as Japan, Taiwan, and Australia are currently suffering collateral damage from this clash with China and would obviously be grateful for resolution.

However, this is not to lose sight of the fact that the other element of the Trade War, the specific policies aimed (perhaps quixotically) at trying to limit Chinese growth, are very much still on the table. The issues over Huawei are perhaps the most visible aspect of this, but it does introduce a level of policy-dependent idiosyncratic risk for portfolios.

Policy is not always negative however, particularly in China, where we notice a clear shift away from coal towards natural gas, encouraged by government with a strong focus on the environmental aspects, particularly air pollution. China Resource Gas, who we met with last month confirmed that 70% of their new customers are coming from the coal to gas conversion initiative. At the household level, the government plans to increase connections from 340m people today to over 500m by 2030 while an even larger initiative is underway at the industrial level including power. There is a long way to go clearly, natural gas will still only be 10% of the mix by 2020, while coal will be 58%, but this is up from 5% in 2013 and represents a long term structural trend.

Around 50% of the imported gas will be LNG, making terminals and ships promising areas for investment while in the North more will be provided by a pipeline connection to Russia. Of course, imports of LNG from the US are one of the available discussion points in the trade talks. With the dramatic turnaround from importer to exporter of LNG thanks to the fracking revolution in the US, President Trump is keen to encourage the rest of the world to buy US LNG. This has so far taken the form of trying to persuade the Europeans not to take so much gas from Russia, notably with reference to the Nordstream gas pipeline, but also for the Chinese to take more gas to improve the trade balance. I continue to believe that China will be more than willing to do this – at the right price – as anti-pollution, along with anti-corruption is a keystone of a policy aimed at social stability. This is also reflected in initiatives such as Shenzhen having switched to all electric buses and a significant portion of their electric taxi fleet. As previously discussed, my last trip across the border a month or so ago felt noticeably different at ‘street level’. The city has transformed itself into a tech hub in the last five years and now has the second most skyscrapers (buildings more than 200m high) in the world after Dubai.

While this shift to electric and gas rather than coal will undoubtedly please environmentalists, on the other hand, data on China energy consumption shows that China’s net imports of crude oil is now exceeding 10m barrels a day as wage growth at the lower end is taking a large number of migrant workers above the threshold of around RMB3,500 a month at which they increase personal mobility. This does not mean car ownership, but it can involve ride sharing and taxis and also weekend trips and occasional flights. As with everything in China, a lot of people having a modest shift in spending can have a big impact.

Not everything is rallying this year however. India is down, which is interesting as not only is it a perennial favourite with international investors, but while in Australia I was asked on several occasions while being constructive about China “What about India?” as the old BRIC association was raised. Obviously, there is concern that there is an election this and the euphoria around Modi that greeted his election in 2014 has faded to say the least, with the ruling Bharatiya Janata Party (BJP) party recently failing to win any of the five state elections that took place before Christmas.

However, as an investor I have other concerns, notably about the extent and composition of India’s growth compared to China as well as the fact that since 2013 the Chinese currency has depreciated 8% against the US Dollar while the Rupee has dropped 31%. Household spending is still around 54% of GDP in India, whereas now it has risen to almost 80% of GDP in China, making for a far broader range of potential investment opportunities. One of the lines I have been known to use when talking about China is that when I came to Hong Kong just over 5 years ago I was confident in my views on China. After all, I was a global fund manager, had visited China regularly and met companies who did business there. I quickly realised however that my views were around 5 years out of date and noted that when I go back to Europe or the US today, the consensus views are still similar to the ones I held 5 years ago. In other words, they are now ten years out of date. I also noted that when I came to Asia, India was said to just about to catch up with China and that 5 years on, it still is. Both have grown by around 45% in dollar terms over the last 5 years, but India, at around $2.7tn GDP is still only a fifth of China at $13.6tn. Indeed, over the last five years China has added the equivalent of another Germany to global GDP, while India has added the equivalent of another Turkey. To refer to the earlier point about skyscrapers, China completed 89 last year alone, (more than the entire stock in New York) while India built four. Indeed, on the definition of buildings greater than 200m high, that doubles India’s stock to 8.

Chart 3: China is now almost twice the size of all the other BRICS combined

Source: Bloomberg, AXA IM Research January 2019

Chart 3 from my colleague Aidan Yao in the Research team shows the difference at the aggregate GDP level, but I really like the following graphic he sent me that compares the two major Asian economies in terms of a much wider variety of statistics, highlighting the number of years since China was at the same level as India is now. The data is slightly out of date, but the gap is likely not.

Chart 4. How many years is India behind China?

The final chart below tells a fascinating story of two brothers and two stocks, one of which dominated the market returns last year. Last year Mukesh Ambani topped the Bloomberg Billionaires list for Asia, with a net worth of $49bn, based almost entirely around his stake in Reliance Industries, having seen the shares triple over the last five years. By contrast, his younger brother Anil, who had a net worth of around $45bn back in 2007 according to Forbes Rich list on account of his stake in Reliance Telecommunications, which he inherited back in 2005 and listed in 2006 is now down to his last $1.3bn, the share price having fallen 95% in the last five years alone.

Chart 5: Which Reliance did you mean?

Source: Bloomberg, AXA IM February 2019

Competition – not least from the re-entry into the Telecoms business by his brother last year- and a series of failed deals, as well as the heavy investments required in the industry have brought Reliance Telecom shares down from the dizzy heights of Rs821 in January 2008 to around 5 today. Old economy Oil and Gas has trounced New Economy Telecoms comprehensively.

This is not to say that India is not interesting. Part of the reason to be interested in India is that it looks likely to be a key battleground between the US and China, especially in terms of FDI and the fourth industrial revolution. Facebook, Amazon, and Google will almost certainly match off against Tencent, AliBaba, and Baidu in competition for India’s consumers. If they play their cards right, the Indian government might just get competition between the world’s two biggest economies to deliver the infrastructure boost they need.

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