This note was originally published September 03, 2013 at 18:13 in Macro
HUNTING FOR ASIAN EQUITY ALPHA:
LONG SOUTH KOREA VS. SHORT CHINA?
- At 14.8% and 15.6%, respectively, China and South Korea represent the two largest geographic weights in the iShares MSCI Emerging Markets Index Fund (EEM). More importantly, we think the latter is poised to take market share from the former, as we believe the South Korean and Chinese equity markets are poised to diverge with respect to the intermediate-term TREND.
- All told, we think South Korean equities look increasingly attractive with respect to the intermediate-term TREND, while the attractiveness of Chinese equities on that same duration is poised to roll over after a proactively-predictable dead-cat bounce in both market prices and Chinese economic data.
- This view is supported by our quantitative risk management setup, as the KOSPI Index is bullish TREND and the Shanghai Composite Index is bearish TREND. As an aside, we think the latter index is likely to threaten a TREND line breakout over the next few weeks on the strength of what is likely to be the last month of sequentially accelerating growth data (SEP), but ultimately fail to confirm any move north of our 2,123 TREND line.
- From an intermediate-term TREND perspective: Chinese growth is poised to roll over in 4Q as inflation continues to accelerate from a low base; South Korean growth should continue its solid trend of acceleration as inflation accelerates from an extremely low base.
- From a long-term TAIL perspective: Structural banking sector headwinds are likely to continue to depress Chinese economic growth; South Korea’s corporate earnings outlook is increasingly complicated by the likely resurgence of Japan Inc.
***Tomorrow (Wednesday, September 4th) at 11:30am EDT, please join the Hedgeye Macro Team for a ~15min conference call titled “Paddling Upstream?: Navigating #EmergingOutflows”. On the call, Senior Analyst Darius Dale will host a live Q&A session regarding recent developments in EM financial markets and our outlook for those asset classes and the economies that underpin them. CLICK HERE to download the accompanying 80-slide presentation, which we will allude to throughout tomorrow’s call. We look forward to your participation and fielding any follow-up questions you might have.***
At 14.8% and 15.6%, respectively, China and South Korea represent the two largest geographic weights in the iShares MSCI Emerging Markets Index Fund (EEM). More importantly, we think the latter is poised to take market share from the former, as we believe the South Korean and Chinese equity markets are poised to diverge with respect to the intermediate-term TREND.
We’ll begin our exposition of this thesis with the assumption that you’re familiar with our latest work in the context of our #EmergingOutflows and #AsianContagion themes. To the extent you are not, we encourage you to review the aforementioned 80-slide presentation; we detail our outlook for the Chinese economy on slides 6-11, 38 and 57-72; we detail our outlook for the South Korean economy on slides 6-11 and 38.
With that knowledge in hand, we think now is the time to buy dips in the Korean equity market and that we’re in a 2-4 week window of loading up on the short side of Chinese equities again, as the current dead-cat bounce has become increasingly long in the tooth.
This view is supported by our quantitative risk management setup, as the KOSPI Index is bullish TREND and the Shanghai Composite Index is bearish TREND. As an aside, we think the latter index is likely to threaten a TREND line breakout over the next few weeks on the strength of what is likely to be the last month of sequentially accelerating growth data (SEP), but ultimately fail to confirm any move north of our 2,123 TREND line.
From a GIP perspective, the South Korean economy is likely to reside in Quad #2 for the balance of the year, while the Chinese economy looks to be transitioning from Quad #2 to Quad #4 in the upcoming quarter, which is a headwind for equity market appreciation.
The aforementioned GIP forecasts are determined by our predictive tracking algorithms for each country’s respective growth and inflation statistics and, like any model, are subject to varying degrees of tracking error – though a lot less than whatever the sell-side has been using to forecast growth, inflation and policy deltas over the past 3-5 years!
As such, we must rigorously track the relevant high-frequency economic data for clues to the degree and directionality of said tracking error – to the extent there is any:
CHINA: GROWTH POISED TO ROLL OVER AS INFLATION ACCELERATES FROM A LOW BASE
- The respective trends in the YoY deltas of the monthly averages of rebar, iron ore and coking coal, as well as the respective trends in Manufacturing PMI, New Orders PMI, New Export Orders PMI, Real Estate Climate Index, Industrial Production, Retail sales and FDI support an improving near-term growth outlook. The respective trends in the monthly average of China’s sovereign yield spread (10Y-2Y), Backlogs of Orders PMI, Non-Manufacturing PMI, Fixed Assets Investment, Total Social Financing, Monthly New Loans, Industrial Sales, Industrial Profits, M2 Money Supply, Consumer Confidence, Exports, Imports, the Trade Balance and sovereign fiscal expenditures all suggest the current uptick in Chinese growth may be short-lived.
- The respective trends in headline CPI, Food CPI, headline PPI, Raw Materials PPI and the trend in the YoY deltas in the currency market all support a hawkish inflation outlook.
- The trend in OIS with respect to the benchmark rate supports a demonstrably tighter monetary policy outlook, though we’d argue much of this is due to the market’s expectation of persistent liquidity constraints (more on this below).
SOUTH KOREA: GROWTH SOLIDLY ACCELERATING AS INFLATION ACCELERATES FROM AN EXTREMELY LOW BASE
- The respective trends in Non-Manufacturing BSI, Employment, Retail Sales, Consumer Confidence, Capacity Utilization, CapEx, Construction Orders, Exports and Imports all support an improving growth outlook.
- The respective trends in headline CPI and headline PPI both support a hawkish inflation outlook, as does the trend in the YoY deltas in the currency market.
- The trend in OIS with respect to the benchmark rate supports a marginally tighter monetary policy outlook.
In addition to tracking high-frequency economic data, we must also have a good handle on the idiosyncratic factors that may influence or dictate a country’s 1-3 year GIP outlook:
CHINA: STRUCTURAL HEADWINDS AREN’T FULLY UNDERSTOOD BY MARKET PARTICIPANTS – LET ALONE PRICED IN!
- Across the maturity curve, interest rate swaps continue to trade well above the current cost of capital in China. In the past, we’ve interpreted this market signal as a sign that monetary policy tightening was increasingly probable over the intermediate term. We don’t view that scenario as likely at the current juncture; rather, we believe the market sees what we see: a prolonged erosion of financial liquidity, at the margins, will continue to apply upward pressure to money market rates over the intermediate-to-long term.
- That erosion of financial liquidity can be further identified via recent activity in China’s local currency bond market. In the QTD, there have been 27.1B CNY ($4B) of pulled bond sales, while AUG’s 240.9B CNY of issuance is down -17% MoM. Moreover, 10Y AAA bond yields have widened +53bps QTD to a ~2Y high of 5.67% and the spread between AAA yields and Chinese sovereign yields just hit a 3M-high of 168bps wide. Lastly, China’s 10Y-2Y sovereign yield spread has widened modestly off its JUN mini-crisis spread lows, but it has yet to buck the trend of tightening that has been in place for over one year now.
- The mere fact that both ends of China’s sovereign debt market is selling off should be interpreted as supportive of our view that the Chinese economy will be increasingly liquidity constrained, at the margins, as NPLs – both of the reported and unreported (i.e. debt rollovers/evergreening) genres – accelerate sustainably. A dour secular outlook for “capital” flows via the trade surplus is also supportive of our liquidity constraint thesis.
SOUTH KOREA: HOW WILL THE MARKET CONTINUE TO PRICE IN INCREASED COMPETITION FROM JAPAN?
- Just isolating its top three export markets, South Korea competes head-to-head with Japan in 41.6% of its exports, so naturally, the JPY’s -24.1% YoY decline vs. the CNY and its -21.3% YoY decline vs. the USD has weighted on the outlook for South Korean export growth. That’s a headwind for broader economic growth as exports are equivalent to 56.5% of South Korean GDP.
- Perhaps more importantly with respect to the thesis we are attempting to explicate, is the fact that an outlook for secular yen weakness directly calls into question the earnings outlook for KOSPI Index. Specifically, both South Korea and Japan are particularly exposed to the global CapEx cycle (Tech and Industrials) from an equity index perspective at 40.6% and 28% of total market cap, respectively (vs. a regional average of 20.2%).
- To the extent customers are competing on price in this naturally deflationary segment of the global economy, it can be argued that a meaningful portion of corporate profit growth in Japan (+24% YoY in 2Q vs. +6% YoY in 1Q) is likely to come at the expense of corporate profit growth in South Korea. It’s hard to be long and strong South Korean equities with respect to the long-term TAIL if you share our bearish bias on the Japanese yen (we think the USD/JPY cross can traverse its way to 125 over the next 12-18 months).
All told, we think South Korean equities look increasingly attractive with respect to the intermediate-term TREND, while the attractiveness of Chinese equities on that same duration is poised to roll over after a proactively-predictable dead-cat bounce in both market prices and Chinese economic data.
We look forward to your participation on tomorrow’s flash call.