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Invesco: Emerging markets, China, and the road ahead

Please see below for one of Invesco’s latest investment articles, received by us yesterday 07/07/2021:

A year and a half after the first reported cases of a new SARS-like virus in Wuhan, China, we can now look back with greater clarity on a period of some of the most dramatic volatility since the Asian and global financial crises. Here, we assess what this volatility and the associated policy responses have meant for China and emerging markets and plot a dotted line for the road ahead.

Looking up after locking down

At the time the pandemic hit, the unresolved US-China trade war loomed large and global manufacturing was in the early stages of restructuring to accommodate new trade patterns. Despite this, China stood out from other countries in terms of its fiscal, monetary and industrial policy response.

Beijing’s policy decisions focused on maintaining domestic productivity and employment with as little disruption on the demand side as possible. Manufacturers were given liberal access to capital to maintain operations, and refunds on social security tax and unemployment insurance incentivised businesses to retain staff without layoffs.

At the same time, the central bank lowered its reserve requirements and removed blocks on certain loan extensions and renewals. Investments were made in traditional infrastructure projects like housing and transportation, and spending on the nationwide 5G network was accelerated.

As a result, China moved from having a GDP contraction of almost 6% for the first quarter of 2020 to being the only major world economy to print a positive GDP growth number for the year.

A dolorous relationship?

While China’s growth in 2020 is unmatched, the road ahead is not unwinding, particularly when we consider the impact that US policy decisions could have on the US dollar.

The growth of the US fiscal balance sheet in 2020 (accommodated via easy monetary policy) appears to have stimulated real inflation in the US economy – an outcome which has led to talk of tightening. If asset purchase programmes are tapered or rates increased, the likely outcome is a stronger dollar.

Historically, a strong dollar has been negative for emerging markets, as it increases the burden of US dollar-denominated debt. This is less of a factor today than it was prior to the Asian and global financial crises. However, the fact remains that this could dampen growth prospects in some emerging market economies.

Commodities buck the trend

In spite of the observation noted above, it is likely that a stronger dollar will benefit firms selling commodities into US dollar-denominated markets, as long as there is global demand for these products. This factors into the dramatic outperformance we have seen from steelmakers, iron miners, commodity chemical companies, and even coal producers.

The demand behind this outperformance is not part of the same super-cycle seen after China’s admission to the World Trade Organisation, when investment in capacity and infrastructure facilitated the country’s transition to the so-called ‘world’s factory’.

Even when we account for the fact that some of this capacity has moved to other countries in the context of trade realignment, the overall demand for commodity materials is not in the same league as two decades ago.

Instead of a broad, sustainable growth in demand, we are seeing a short-term build-up of inventories that reflects ‘new normal’ uncertainties about tariffs and pandemic lockdowns. This goes all the way through the product cycle, from raw materials to finished goods.

Although these dynamics are almost certainly near-term and should subside in the medium-term, they do attract speculation that disrupts the market.

The road ahead

What does this disruption mean for emerging markets? In the absence of significant inflows, there is a conservation of capital within the asset class. The sharp and transitory shifts described above get funded by parts of the market that have outperformed — in this case growth companies, in particular those in China. In this sense, China has been a victim of its own success as far as its response to the pandemic is concerned, as some investors look to lock-in potential gains.

That said, in our opinion, these sharp transitions do not signify a change in the long-term view for emerging markets. The types of firms that create and capture value for shareholders remain the same.

Even with an ageing population, China remains a large economy with an outlook for sustained, high-speed growth. The growing middle class offers opportunities for investment in education, real estate services, and world-leading innovative technology platforms that facilitate consumption.

It is worth adding that the size and scale of the domestic market should make it less susceptible to external volatility than other markets in the asset class.

What these transitions offer, then, is the potential to invest in the best long-term opportunities at more attractive valuations than normal market conditions afford. 

Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.

Keep safe and well.

Paul Green DipFA


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Ravenscroft: A post-pandemic boom is possible…

A blog cut and pasted from an email received from Kevin Boscher, Chief Investment Officer at Ravenscroft, late yesterday afternoon, 30/12/2020.

A post-pandemic boom is possible…
 As we approach the end of an extraordinary year, in which nobody could possibly have predicted the unprecedented events that have unfolded, it is time to look forward to what 2021 may hold in store for the global economy and financial markets. The good news is that I remain optimistic that we will likely see a recovery boom over the next year or so and that this will be a positive backdrop for equities, in particular. It is true that most stock markets have already recovered strongly from their March lows and that a considerable amount of good news may be priced in already. In addition, with Europe and the US struggling to cope with a resurgence in the virus, which is necessitating further restrictions and threatening the nascent pick-up in activity, it’s also clear that the global macro environment remains challenging. However, despite this I believe that the outlook remains very supportive for both economic activity and financial assets.

History has repeatedly shown that equities require three main attributes to generate favourable returns; decent growth (both economic and earnings), plentiful liquidity and reasonable valuations. Beginning with the growth outlook, activity is recovering much better than expected with Asia leading the way. For example, retail sales in the US and Europe have not only clawed back all of their lost ground, but have made new highs. This is largely thanks to the “shock and awe” monetary and fiscal support from all of the key global policymakers. However, it is also partly due to the fact that consumers and businesses have quickly adapted to the new environment, thanks largely to the use of technology

Effective Covid-19 vaccines will unlock tremendous pent-up demand around the world as everyone is able to live a more normal life again. As savings rates have risen dramatically in the US, Europe and elsewhere over recent months, this will help fund a consumption boom over the next year or two.

At the same time, companies will need to increase investment to keep up with accelerating demand and boost productivity whilst governments will continue to spend heavily, financed by central banks. Global trade is also picking up at a material pace. Hence, all engines of growth will be working in tandem to fuel the boom.

Another positive factor is that although this pandemic-induced crisis is a transitory shock, like most natural disasters, it has resulted in structural shifts in policy.

This will make the recovery story very different from the post-Global Financial Crisis (GFC) recovery of 2009, when the world economy was plagued by a badly damaged banking system in the West, prolonged deleveraging and a collapse in Chinese investment spending.

This resulted in a long period of sub-trend growth, a sustained deflationary threat and a secular downturn in commodities. The global economy is recovering fast but governments and central banks are still worried about a “double dip” and renewed weakness and will continue to inject larger amounts of money into the economy.

So far, fiscal support has largely been focused on providing income support for individuals or businesses. Going forward, the emphasis will shift to rebuilding the economy and boosting long-term productivity and growth through investment in infrastructure, digitalisation of the economy, upskilling and environmental projects. This additional fiscal support, which will be financed by central banks, will simply add more fuel to the potential recovery in spending and investment over the next few years.

The increased infrastructure spending will also likely lead to a significant pick-up in construction activity, which in turn should be good news for commodity prices.

Two other features are supportive of the growth story. I expect the dollar to depreciate further over the next few years as the Fed keeps rates at zero whilst maintaining its bloated balance sheet, since real rates are lower in the US than in both Europe and Japan and because the magnitude of the “twin deficits” dwarfs any other major economy. Secondly, whilst the Brexit agreement will still bring about considerable disruption to trade and commerce across both the UK and Europe, it should result in a much better outcome than many had feared. A strengthening world economy is clearly positive for corporate profits and equities. Earnings have generally held up better than expected this year and analysts have already revised upwards their estimates for 2021 and beyond.

With economic growth forecasts also improving pretty much everywhere, we will likely see additional positive revisions for earnings over the next few months.

From a liquidity perspective, this is likely to remain plentiful and helpful for financial assets. Central banks have little option other than to help finance the increased government spending, thereby effectively monetising the debt and keeping financing costs extremely low for governments, corporates and consumers. Global debt levels are at record highs and in excess of 400% of GDP, compared with c. 280% post the GFC in 2009. These levels will continue to rise over the medium term, even as activity recovers. Not only will central banks, led by the Fed, keep interest rates at current levels for several years, they will also continue to expand their balance sheets and enlarge their quantitative easing (QE) programmes in order to absorb the issuance of government debt and support the economic recovery and financial assets. Financial repression is very much intact and bond yields will be kept low across the maturity range in order to force investors further up the risk scale in a search for yield. This is also a supportive environment for corporate bonds, especially high yield and emerging market debt.

All of this newly created money is unlikely to create inflation over the next year or so but it will flow into financial assets and eventually, economic activity. The secular disinflationary forces remain powerful and are a natural result of an ageing and high-income economy, where desired investment gravitates lower and eventually falls below available savings. This is true across Europe, the US and Japan where central banks have tried and failed for over a decade to generate higher inflation. The pandemic has intensified the excess saving problem at the same time as accelerating technological advances are driving down costs and boosting productivity, thus adding to the downward pressure on prices.

Eventually, inflation will almost certainly pick up as aggregate global demand starts to move ahead of supply and as credit demand and the circulation of money starts to accelerate.

However, this would be a welcome development for policymakers as they target higher nominal growth in order to inflate away the debt problem.

Looking at valuations, it is true that the mega-cap technology and growth stocks look expensive, which in turn pushes up the overall valuation of the US markets. However, there are many markets, sectors and stocks, which look good value, both in absolute terms and relative to their own history.

For example, UK equities look outright cheap as do several emerging markets. In addition, small and mid-cap stocks in many markets look attractive given accelerating growth whilst value stocks are at multi-decade lows versus their growth counterparts.

Old economy cyclicals, like industrials, materials, energy and financials, are all well positioned to benefit from a possible boom in economic activity and any sector rotation. Meanwhile, Covid-19 victims, like airlines and hospitality companies, have potentially huge hidden value, which could be unlocked by effective vaccines.

A couple of other factors support the valuation argument; given the unprecedented collapse in demand and earnings during the lockdowns, it is still too early to assess, with any degree of accuracy, the full impact on valuations, either for this year or next. Earnings could bounce back strongly in line with activity. Secondly, equities continue to look good value relative to bonds and cash and this is likely to stay the case for some time to come. Equities can trade on higher valuations for long periods of time when interest rates and the discount rate are so low and negative in real terms.

As already explained, whilst I am optimistic on the outlook, I also acknowledge that the background macro picture remains challenging given the below-trend growth and disinflationary secular forces and the cyclical deflationary Covid-19 shock. For me, the biggest threat to markets or the economic recovery going forward is policy error from any number of sources. For example, should the US fail to implement another effective fiscal stimulus programme or if the Fed doesn’t extend its QE programme sufficiently, this could be problematic. Similarly, if China starts to tighten policy prematurely in order to focus on reducing leverage, credit creation and excess capacity, then this would weaken global growth and add to deflationary forces. Also, any escalation of US/China tensions would be unwelcome at this stage. A second risk is that the planned vaccine programme disappoints in any way, i.e. the roll out is not as quick as hoped, more people than expected refuse to take it or it is less effective than anticipated.

Any adverse media from such outcomes could spook investors and the stock market, although I doubt they would kill the recovery or alter the positive medium term trend. Other key risks include the rise of political extremism, increasing hostility towards China in the West, a possible increase in business failures once government support ceases or an earlier pick-up in inflation than anticipated.

The key drivers for markets over the next year or so will likely be the unprecedented monetary and fiscal expansion together with the success of the vaccines. Assuming this goes as expected, 2021 should be another good year for equities and other risk assets.

As I have written about previously, the core irrefutable and long-term themes, which have performed so well for us at Ravenscroft over recent years, remain very attractive and are likely to generate superior returns for years to come. These include technology, healthcare, the emerging consumer, emerging markets generally and environmental related stocks.

I am also positive on the outlook for gold and commodity-related stocks generally, again as I have previously explained. Some of the more cyclical and beaten up stocks are also likely to perform strongly next year and we will look to benefit from this where appropriate. In the meantime, we remain cognisant of the multiple threats to this rosy picture and will continue to look for surprises which could negatively impact the outlook.

This has been a year like no other from an investment perspective and although it has felt tough at times, I think we are all somewhat relieved at how quickly things have recovered.

I am hopeful that the global economy and financial markets can continue to improve in 2021 and beyond and that we can again generate attractive returns for our clients through a combination of active management, strong research and our thematic approach.

Positive input from Ravenscroft to finish the year on.  Taking a wider view on input this year we generally expect investment returns to be lower for longer and for clients with a lower risk profile, circa 5/10 (‘Low Medium Risk’), a very diverse range of assets will be needed to generate reasonable long-term returns within their risk profile.  Long-term is 10 years plus.

For higher risk investors more equity content will help, but you will experience higher volatility.  This is fine if you have the right risk appetite, capacity for loss and timeframe or flexibility of timeframe to invest.

All the best for 2021 – a happy, healthy, and prosperous New Year to you and yours!

Steve Speed