THE INDIAN ECONOMY & EQUITY MARKETS; A VERY MESSY TRANSITION
Concerns that the second Modi administration will move India back towards a system of Nehruvian socialism or an Erdogan-type of authoritarianism appear misplaced. Instead, Modi will leverage all of the (limited) tools at his disposal in an effort to realise the transition from connections to rules-based capitalism, whilst trying to maintain economic growth at an ‘acceptable’ level. Despite the bankruptcy law and other reforms, the immediate outlook for the Indian economy is extremely negative, given the likely further weakening in the external environment, mainly driven by China and the near-paralysis in the banking sector, which is likely to persist for some time.
India remains the most expensive of the 48 markets in the Ecstrat global equity universe, while investors and analysts are too optimistic about the outlook for corporate earnings over the medium term. True, the ongoing decline in interest rates, which has pushed bond yields down to their lowest level since GFC, is bullish for equities but recent market weakness indicates a tipping point when the poor growth and earnings outlook begins to outweigh the impact of lower rates, especially as Indian equities generally trade on relatively low dividend yields. Despite this, I remain neutral in an EM context having downgraded from overweight last June, as India has relatively little direct exposure to the China factor. Within emerging Asia, I stay overweight in Indonesia, Thailand and the Philippines and underweight in China and Korea.
Q3 EM EQUITY OUTLOOK BY COUNTRY
The strategic outlook for positive absolute and relative returns from EM equities remains poor, mainly due to the jeopardy facing the Chinese economy and financial sector. Although the current round of stimulus efforts might generate a brief sugar rush in the financial markets, an increasing proportion of the proceeds will prop up potentially insolvent industrial companies and local governments, along with economically unviable infrastructure projects. While the current issues in the interbank market are unlikely to be the start of a systemic crisis, they are indicative of the growing fragility of the Chinese economy and financial system, due to the build-up of moral hazard and Beijing’s failure to implement market-oriented reforms.
Notwithstanding the prospects for a truce in the US/China trade dispute, more systemic areas of difference will deepen the estrangement between the West and the China/Russia axis to an extent that will partially reverse the post-1991 settlement and impose costs upon all of the major global economies. As the political and economic systems of these two blocs continue to diverge, there will be increasing pressures on institutions to divest from the West’s major antagonists for political and ESG related reasons, with Marco Rubio’s recent letter to MSCI most likely the start of a key shift in the mindset of US policymakers, so index based investment in EM will no longer be a viable strategy.
Russian Equities; Looking out to 2024
At present, the Kremlin appears to be in a position to determine the presidential succession in 2024. In the first two of five scenarios highlighted in the full report, Putin is either able to select his own successor or else manages to change the constitution by adopting the Belarus or more likely the Kazakh variant, in order to retain power himself. There is however evidence of increasing rivalry within the Russian elite which might result in a contested succession, while pressure for a change from below will rise if the Russian authorities fail to address issues such as service delivery, corruption and above all the big drop in real household incomes.
The current consolidation of power, assets and rents around the Kremlin establishment with the siloviki seemingly in the ascendant, is likely to lead to a further redistribution of assets and cement the estrangement from Western countries, companies and investors. The continuing expansion of the role of the state in the economy as the central part of the shift towards a more Autarkic Governance Regime, bodes ill for future productivity and economic growth. The further blurring of boundaries between the private and state sectors means more moral hazard and possibly greater hidden financial risks, given the increasingly opaque financing structures.
CHINA: AUTARKY, MORAL HAZARD & INDEX FLOWS
Following the US move against Huawei, China’s reliance on the goodwill/self-interest of the US and its allies has become even clearer. Without access to Western components and technology, Beijing’s strategy of moving up the value-added chain to surmount the middle-income transition becomes much harder. Over the past two years, China has also started to depend upon inflows of money from overseas portfolio investors as external surpluses dwindle. However, the rising weighting of Chinese onshore listed bonds and equities in the most widely followed benchmarks appears increasingly anomalous as direct investors start to de-integrate China from their global supply chains.
Notwithstanding the likelihood of a tactical rally if there is a partial settlement to the trade and/or Huawei disputes, the longer term prospects for investors in the Chinese equity market(s) remain bleak due to i) slower productivity growth and rising debt levels driving a further deterioration in economic growth possibly leading to a significant financial event; ii) the Chinese authorities increasingly mobilising all available resources to head off such an event including those under the nominal control of the listed corporate sector; iii) the accumulation of significant moral hazard in the corporate and financial sector exacerbating the impact of a poor economy; iv) the possibility of more US sanctions and other measures against Chinese companies; v) the prospects for further weakness in the renminbi due to falling confidence and a looming dollar shortage.