The highly regarded analyst thinks emerging market stocks will outperform developed markets.
“Taking a call from the Taiwan president was a negative signal by the president-elect; naming Iowa Gov. Terry Branstad to be his nominee for ambassador to China was positive.“ —Christopher Wood Virgile S. Bertrand for Barron’s
Before he became the strategist for CLSA Asia-Pacific Markets, Christopher Wood was the Tokyo bureau chief for the Economist and a writer of books. For 20 years, he’s produced the opinionated, richly detailed Greed & Fear newsletter, a weekly must-read for global investors interested in Asia and the remainder of the world.
We checked in with Wood, a highly regarded analyst, to see why he has turned positive on China, what the incoming U.S. administration might mean for Asia, and why he contends that Indian Prime Minister Modei was right to withdraw 86% of his nation’s money from circulation. Keep reading to learn more.
Barron’s: You recently upgraded China to overweight from underweight. Why?
Wood: The most important reason is that Chinese producer-price inflation turned positive three months ago. We hadn’t had one positive PPI reading since early 2012. It has very good correlation with nominal gross domestic product in China. The PPI turned positive not just because of stronger demand, but also because we’ve had some evidence of what the Chinese call supply-side reform. The biggest evidence of discipline on the supply side this year has been in the coal sector. For 2017, we are mainly being told of a possible reduction of capacity in steel. The key issue is that supply-side reform continues next year. That creates a cyclical backdrop. The second point is that investment in the manufacturing sector looks like it is recovering.
There’s a bit of relief because the currency is weakening a bit. These companies have just been through several years of high real interest rates. The H shares in Hong Kong are cheaper than the ones in Shanghai, so I’m upgrading MSCI China, not Shanghai. We’ve seen trading volumes pick up in the last three months.
In the short term, money-market rates are rising in China because of the People’s Bank of China, which is pressuring the market. That’s partly because the PBOC has already hit its growth target of 6.5% to 7% this year, and because the renminbi is under pressure again because the dollar is so strong. If you want to play China, you have to play the infrastructure related stocks, like China Communications Construction [ticker: 1800.Hong Kong]. The Hong Kong quoted H shares trade at a big discount to the A shares.
Aren’t you concerned about rising Chinese credit?
It’s growing at a very rapid rate. Total credit in recent years has continued to rise at almost double the level of nominal GDP growth because of shadow banking. If it continues for the next three years, there’s a great chance of a financial crisis in China. But the real risk, in my view, will come when the whole system no longer depends on bank deposits, but on growing the shadow financial system. The official loan-to-deposit ratio is only about 70%. But in my view, it’s around 100% right now. If it gets to 120% to 130%, then we’re more likely to have a financial crisis in China. The problem wouldn’t be with the big banks, which are 40% of the system, it would be with the smaller banks. But the Chinese officials are aware of the problem. It’s not like the U.S. in 2006, when the Fed didn’t know there was a problem. We just have to monitor it.
What’s your longer-term outlook for the Chinese currency, a flashpoint with the U.S.? It’s now nearly at 7 to the dollar after bouncing around 6.4, and President-elect Donald Trump may label China a “currency manipulator.”
The Chinese are now targeting a trade-weighted basket, not the dollar peg. If the dollar keeps strong, the renminbi will go weaker. They don’t want the currency to collapse. China will wait to see what happens [with the Trump administration]. Taking a call from the Taiwan president was a negative signal by the president-elect; naming Iowa Gov. Terry Branstad to be his nominee for ambassador to China was positive. There are some sophisticated guys in the incoming administration—Wilbur Ross, the Commerce secretary who is a billionaire investor; [Rex Tillerson], the secretary of state, who currently runs Exxon Mobil—who understand the world and I’m hoping someone will explain to him that China is the one country that for the last 10 years has not been trashing its currency.
It is all about where the 10-year yield is. What I’m going to be watching is whether Trump implements his corporate tax reform. Does he get the $2.5 trillion [corporate cash sitting offshore] back to America? Will he do the infrastructure spend? Short-term, I think the U.S. Treasury 10-year yield can go to 3% from 2.6% now. The more Treasuries sell off, the bigger pushback you may get on fiscal easing. His basic tax reform will create huge incentives for Corporate America to move production onshore. That is a bad thing for the guys in the supply chain. It is a bad thing for Apple [AAPL] and for Asia. If Trump’s policies work—which is a big if—they will be inflationary, meaning a weaker dollar, stronger gold.
What else will a 3% U.S. 10-year yield bring for Asia?
My thesis was that the Trump election would trigger a bond riot [a sudden rise in yields]. That’s obviously happened. There has always been a big correlation between the Topix and the U.S. Treasury market, Japan was already cheap, and the Bank of Japan a few months ago committed itself to fixing the yield of the 10-year Japanese government bond at zero. If the 10-year Treasury yield goes up, it increases pressure on the 10-year JGB yield to go up. If the 10-year Treasury goes to 3%, the yen will weaken beyond 120 from 117 now. So go long Japanese financial stocks like Dai-ichi Life Holdings [8750.Japan] and T&D Holdings [8795.Japan], both life insurers, and short the yen.
What does a rise in yields mean for the rest of Asia and for emerging markets?
Short term, everyone made a lot of money in emerging- market debt and sold positions to lock in gains before the calendar year ends. That’s why emerging market currencies got hit. Longer term, I’d say it’s a good opportunity for emerging market debt, which is far better than G-7 bonds. Emerging market equity will outperform because of lower valuations, better macro fundamentals, and lower debt than the G-7. I’m not expecting China to collapse. Obviously, the U.S. will try to improve infrastructure, but the biggest infrastructure story globally is China. Saudi Arabia’s U-turn on oil will help the oil producers. And fundamentally, the best story in emerging markets is the domestic-demand stories, led by India, the Philippines, and Indonesia in Asia. Basically, you want to own the best domestic-demand stories in emerging markets.
Will Asia outperform the world in 2017?
If the Trump story really follows through, it’s a better story for small-cap stocks in America. If the dollar remains strong, it will be a negative for Asia and emerging markets. But in my view, this dollar strength won’t persist in all of 2017. It may peak when Donald Trump walks into the White House.
You remain bullish on India, despite the Modi government’s decision to replace existing 500-rupee and 1,000-rupee notes with new notes.
It is my long-term favorite market in Asia. I’m much more overweight in India than China. This was an amazingly ballsy move. Normally, any currency reform happens in a crisis, and there was no crisis. It’s definitely going to hit growth in the next three to six months, and the rural economy more because the urban economy uses credit cards. Prime Minister Modi is intent on implementing his reform agenda. This is aimed at fat cats who have accumulated cash hoards to remain outside the taxed economy. The slowdown will last three to six months. Deposit growth will significantly increase, giving banks more room to pass on rate cuts to borrowers.
It creates room to improve India’s chronic fiscal deficit. It will support the Indian currency and bond market and is also a longer-term positive for equities, particularly the domestic-demand stories, which have all been trashed. For people who can look beyond three months, those are the stocks to be buying: housing, finance, cement, property, autos, classic domestic demand. The one sector where it may drag out longer is residential property, particularly in smaller cities where black money cash is most widely deployed.
You are positive on the Philippines, despite its volatile new president, Rodrigo Duterte.
I am still overweight, but now have a less positive view. I had a massive overweight in the Philippines for several years, which I had to reduce because of the uncertainty created by the new president. He has already destabilized the currency a bit. The worry is that he destabilizes business confidence.
There is an absolute business-process outsourcing boom in the Philippines driven by U.S. and Japanese companies investing there. If they decide not to continue, that would be a major negative.
What do you dislike in Asia?
Australian banks, which are the most overvalued. But that’s not really Asia.
What about South Korea, whose president was just impeached?
She was doing a very good job—this is unnecessary noise. She tried to make [corporations] raise their payout ratios. She stimulated the domestic economy a few years ago by relaxing draconian measures like a maximum mortgage loan-to-value ratio of 40%. There is potential risk to Asia and production sources from proposed U.S. legislation that would tax imports. It is a risk to suppliers of companies like Apple. I am underweight Korea and Taiwan, partly because of that law, which may not be passed.
Finally, as a big-picture thinker, what do you think of Europe?
The euro zone will break up in the next two years. During the Greek crisis, I thought they would stick together. But [German Chancellor Angela] Merkel’s political support provided cover for [European Central Bank President Mario] Draghi to buy U.S. and government bonds.
Now, Merkel is a less strong position to support Draghi’s manipulations. There is a German election next year. Germans will be very reluctant to endorse moves toward fiscal union. That puts a big question mark on the euro zone. Italy is increasingly likely to walk out in the next two years. It was the euro zone’s second-biggest manufacturer, and it joined the union at too-high rates. At least the other guys had a multiyear party before they blew up. So European equities are cheap and you can make great money trading around them, but you have to navigate these curves and minefields.
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Tags: Apple, Bank of Japan, China, China Communications Construction, China's debt, coal, currency, Donald Trump, Duterte, energy, Europe, Exxon Mobil, financial crisis in China, GDP growth, Germany, Hong Kong quoted H shares, India, Indonesia, infrastructure, Japanese financial stocks, Merkel, MSCI China, Narendra Modi, oil, oil and gas, Park, PBOC, Philippines, Prime Minister Modi, Saudi Arabia, South Korea, stronger gold, supply-side reform, Terry Branstad, Trump’s policies, weaker dollar, Wilbur Ross