probably fair to say that EM equity investors would much prefer the direction of the trends we’re now seeing in European data.
While Europe, like the US, is a consumer led economy, the picture is quite different in China. Over the past three decades, China has invested heavily in infrastructure, becoming the second largest contributor to world investment.
World Bank’s Data Investments From China
According to data from the World Bank, 17% of global investment in 2011 came from China, compared to 15% from the Euro Area, and 20% from US. While contributions from US have stayed flat between 1980 and 2011, Chinese contributions increased 17-fold. Relative to its own GDP, China invested 46% in 2011 compared to the world average of 19%. This upward trend in investment and downward trend in consumption accelerated post-2000, and caused the two GDP components to converge (chart 10).
In our view, the trends in investment and consumption in China are probably not sustainable. One of the key components of the 2012 five year plan was to shift the country away from infrastructure and export led growth, and more towards domestic consumption and inclusive growth. Such transitions are seldom smooth, but with traditional investment experiencing diminishing marginal returns there is a clear impetus for policy makers to attempt to seek to rebalance the economy.
According to our economists, the efficiency of fixed asset investment has fallen over the past few years. The incremental capital-output ratio (ICOR) suggests that in 2012, 6 units of capital were required to produce 1 unit of output, compared to the 3 units in 1991 (Chart 11). So while investment has increased, each unit of investment is less productive and as a result will contribute less to the final GDP number.
Some of this negative outlook is already reflected in market sentiment. Consumer confidence has fallen sharply and is near all-time lows. Manufacturing confidence meanwhile has yet to see such violent moves, but the trend is declining with PMIs hovering around the break-even reading of 50 (chart 12). There is some risk that this data series dips into contractionary territory if the decrease in productivity materialises further in China.
But even if data in China risks declining further it is likely to be less of a surprise to investors than the converse run of positive data in Europe. According to the June Fund Manager Survey investor confidence is declining in China. A net 32% of PMs identified China as the ‘biggest’ tail risk, overtaking Eurozone risk for the first time (chart 13). While PMs are not yet at the crescendo of negativity over China that we saw towards Europe and US during the peak of their crises, the slowdown in Chinese data is hardly new news. Positioning though is already at extremes in several China linked asset classes. Allocation to commodities are at their lowest point since Dec-08 and is within a whisker of all time lows; and the EU mining sector is the worst performing sector on a 1m, 3m, 6m and 12m basis.
The combination of Europe stabilizing from a low base, the wash-out already seen in some of Europe’s China proxies, and acknowledgement of the downside risks to the Chinese data likely mean that EU equities can withstand some further slowing in China. The IMF estimates that China share of global GDP is half that of the US and equal that of Germany, France, and Italy combined.1 At present, consensus estimates for China GDP growth are 7.7% and 7.3% for 2014 and 2015 respectively. Given the relative size of the economies, a 100bp drop in Chinese GDP could be offset by 33bp of upside GDP surprise across US and selected European nations. Nevertheless, Europe’s EM exposed stocks will suffer disproportionately and we are beginning to see EPS downgrades in such sectors.
Which sectors and stocks may be more vulnerable?
The contrasting change in sentiment between EM and domestic EU is beginning to show up in EPS revision ratios. Among European stocks, those with domestic EU exposure are seeing ERR rise while those with EM exposure are seeing ERR fall (chart 14). The ERR for stocks with EM industrial exposure is falling more sharply than for those with EM consumer exposure. This is beginning to manifest itself in the valuation differentials between EM and Domestic exposed stocks in different sectors. Among EU industrials, the premium of EM vs. DM exposed stocks recently declined quite sharply. By contrast for Staples the premium of EM exposed names vs. DM exposed remains near its highs (Chart 15). The pattern appears in somewhat in conflict with the relative moves in Chinese industrial and consumer confidence (Chart 12) and may imply some derating risk yet to be realised in the EM exposed EU consumer stocks.
At a high level, rising EU domestic ERR trends and falling ERR trends for EM exposed stocks reinforces our strategic preference for EU domestic sectors. But delving deeper, the sectors with the greatest EM exposure (based on revenues) are Tech, Food & Bev, Basics, PHH and Chemicals (chart 16). Of these we have a strategic UW recommendation on Food & Bev, PHH and Chemicals, and are strategically Neutral on Tech and Basics. In our view, price action in sectors like Basics suggests that fears over China/EM data are already quite will reflected.
However, in some of the consumer geared sectors, notably PHH, recent price action has been more positive and suggests some vulnerability to any deterioration in China/EM consumer sentiment. By contrast, the EU sectors with the lowest EM exposure are Utilities, Financial Services, Insurance, Travel & Leisure, Media and Banks. We have a strategic OW on Travel & Leisure, Media and Banks, and are neutral on the other three. Our tactical framework (a 1-3 month statistically derived trading signal) has both Utilities and Insurance registering a short term bullish signal (link).
European Union VS Emerging Markets
Stockpickers may chose to play the domestic EU vs. EM/China theme by pairing a short in EM exposed stocks with poor ERR but high valuations vs. domestic EU exposed stocks rising ERR and undemanding valuations; charts 18 and 19 show a quantitative screening of the more and less attractive EM and domestic EU exposed stocks. Several EU Staples and Industrials
