SINGAPORE (July 23): Emerging markets (EMs) have been particularly hard hit by the tightening cycle in the US. On July 17, US Federal Reserve chairman Jerome Powell’s testimony to the US Senate indicated continued rate hikes, given faster US GDP growth expected for 2H2018. Tax cuts are expected to provide demand- and supply-side support to US growth over the next two to three years, Powell said. Also, like other central banks, the Fed sees the US-led trade war setting off alarm bells, but not enough to slow global growth dramatically.

“Inflation surprise would entail the risk of faster tightening than forecast, so bond markets may suffer even more, warranting an underweight positioning on most fixed-income assets,” notes Xavier Denis, head of Cross Asset Research, Lyxor Asset Management. Further tightening would also lead to continued US dollar strength against EM currencies. Against the greenback, the rupiah, ringgit and renminbi have all lost around 6% since the start of the year.

“We have downgraded to neutral on EM equities and we are underweight on EM debt (hard currencies). A stronger USD, tighter USD liquidity and rising oil prices are headwinds to the overall asset class,” Denis says in a recent report. “China could receive some modest overweight, given its closed capital account and solid expansion, despite some growth deceleration.”

The MSCI Emerging Markets Index is down more than 9% in US dollar terms year-to-date. EM and Asian currencies have come off their highs and their markets have underperformed developed markets because higher US interest rates make Asian assets less attractive. Andrew Swan, head of Asian and global EM equities at BlackRock, says a stronger US dollar usually spells trouble for EMs because it makes servicing external debt more expensive for borrowers. “Asia, however, is relatively isolated from this because reliance on dollar financing is significantly lower than in other parts of the world,” he points out.

Swan is surprised by the pace of deleveraging in China. He thought the government would have waited until the economy was in a stronger growth environment. “We have been surprised by how quickly credit growth has slowed. China’s desire to deleverage into a potential slowdown, owing to causes other than trade policy, is a concern that may have been priced into markets.” The Shanghai Composite Index has lost almost 16.18% this year and the SSE Composite Index (SSE 50) has lost 15.2%, according to Bloomberg data.

“We are not seeing this in the economy yet, but there could be a lagged effect from deleveraging that could still come through in the second half of the year,” Swan says. Chinese GDP growth decelerated only slightly to 6.7% in 2Q2018, from 6.8% in 1Q2018.

Nick Payne, head of EMs at Old Mutual Global Investors, thinks a buying opportunity could soon emerge for EMs. He believes the China secular growth story is intact despite the slowdown.

“Irrefutably, the country’s growth is slowing down, while US-Sino trade tensions are casting a shadow over the success of the ‘Made in China 2025’ campaign, a project aimed at promoting robotics and artificial intelligence devices. But the rebalancing of China’s growth from an export-oriented economy to one focused on increasing domestic consumption is unlikely to significantly affect prospects for internet giants Tencent Holdings and Alibaba Group Holding, in our view. Both companies enjoy high returns on invested capital — the key, we believe, to long-term investing,” Payne says.

Can this China-related ETF recover?

The United SSE 50 China ETF, which tracks the much-followed SSE 50 Index, is among the top 10 worst performers among the 70 exchange-traded funds listed on the Singapore Exchange, losing almost 15% since the start of the year (see Table 1). Investors would have lost more because the ETF’s expense ratio is 4.43%. Since it tracks the SSE 50 Index, the ETF’s holdings are heavily biased towards financials (see Chart 1), which have a weightage of 56.5%. Consumer staples comes next with 12.29%, followed by industrials at 8.46% and materials at 6.22%.

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The US threat of expanding the trade war by imposing tariffs on all Chinese exports to the US is a sword of Damocles that hangs over the Chinese market, and provides the market with low visibility. There is concern that the renminbi may be sacrificed (by allowing it to weaken further) to preserve growth. Generally, the finance, healthcare, internet, telecommunications and utilities sectors are likely to experience a limited impact. Consumer staples are likely to be affected — the extent to which the sector is affected would be determined by the companies’ overseas production bases and the foreign exchange they have on their balance sheets. The companies that would bear the brunt of the negative consequences are likely to be in the property and hardware sectors; airlines and auto dealers would be affected too. The consensus view is that tech companies may stay relatively unscathed.

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Credit Suisse lowered its profit estimates for China’s big banks by 4% to 6% earlier this month, because it raised credit cost estimates. The banks are building loan loss reserves that should reach 3% by year-end. At any rate, Credit Suisse believes the downside is limited. It likes Bank of China, which has a 1.67% weightage in the United SSE 50 China ETF, and China Construction Bank. BOC is trading at just 0.6 times book, and CCB at 0.8 times book.

The SSE 50 Index is trading at a price-tobook ratio of between 1.3 and 1.5 times, which is historically undemanding (see Chart 2). Its current 12-month trailing price-to-earnings ratio of just 10 times is at the low end of the range (see Chart 3).

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The One Stoxx Asean Select Dividend (30) Index Fund — comprising 30 of the highest dividend-paying stocks in Asean — was an even worse performer than United SSE 50 China ETF. It is down more than 15% year-to-date, and with an expense ratio of 3.02%, investors would be down more than 18%. The performance comes as no surprise because among its largest holdings are Singapore blue chips, which have continued to fall through the year. Also, the ETF is priced in US dollars, and Asean stocks are priced in currencies that weakened against the greenback.

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The ETF comprises companies from Malaysia, the Philippines, Vietnam, Thailand, Singapore and Indonesia. Malaysian stocks appear to have the highest weightage at 25.95%, followed by Singapore (22.9%) and Indonesia (15.35%).

To be included in the index, a company must have a minimum three-month average daily trading volume of US$2 million ($2.73 million). Companies with payout ratios of more than 80% are excluded, and so are real estate investment trusts. Vietnamese stocks whose foreign investment capacities are below 4% are excluded as well. All remaining stocks are ranked by their 12-month historical dividend yield.

The top 30 stocks are selected by applying a 20:40 buffer rule. A cap of a maximum seven companies per country (five for Thailand) is stipulated to prevent any one country from having too much weight in the index.

These criteria will exclude DBS Group Holdings for this year. Although it paid out a hefty dividend, which gives a yield of around 5%, the payout for FY2017 translates into a ratio of 83.6%.

Malayan Banking and CIMB Group Holdings had fallen to their 2018 lows earlier this month, although Maybank recovered sharply mid-month. Singapore Telecommunications and Keppel Corp are also near their lows, and analysts see limited downside for these stocks.

A path to recovery for both ETFs lies with USD strength. If the USD weakens, Asean currencies and the renminbi would recover.

Markus Rosgen, a strategist at Citigroup, offers three scenarios for EM recovery. Scenario 1 would be the most benign for EMs, that is, the trade disputes end where we are today, common solutions are found and the world moves on. EM valuations are too cheap and would rally back to mean valuations. The Fed would continue to tighten in much the fashion anticipated by the markets and the USD would begin to drift again. “Given the current news flow, Scenario 1 now looks like a low-probability outcome,” Rosgen says.

In Scenario 2, trade tensions escalate and the US slaps further tariffs on Chinese products. If this happens, currencies would fall further, and interest rates would be raised to defend them. Asian EMs would continue to fall. That would be negative for our two ETFs. Eventually, if a solution could be found, emerging Asia would rally. Market watchers are looking at this scenario with hope.

In Scenario 3, the trade skirmish turns into a trade war, with the US levying tariffs on all US$500 billion of its Chinese imports. The global economy would head towards a recession. Currencies of emerging Asia would fall, especially those with large current account deficits, and market valuations could fall to levels not seen since the Asian financial crisis. Scenario 3 would be disastrous for our two ETFs and Asian markets in general.

Emerging-market ETFs look for support as selldown persists

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