Overall, grim. Note: this was before the Chinese rate/RRR cut today and before the story doing the rounds that the govt has taken a decision to stop directly supporting the market. Keeping that in mind Cui’s comments below are prescient & worth a glance.
Ajay Kapur – Asia/GEM equities overall
- -ve on Asian equities, -ve on GEM equities. Valuations aren’t that great & neither are earnings. As Fed withdraws liquidity it will hurt.
- Prefers to look at EV/EBITDA over P/E since EM companies have taken on a lot of debt, especially in China but elsewhere too. EM currently at 7.5x EV/EBITA (vs 4.2x in 2008, & 5.8x in Sept 2011).
- One P/B, EM currently 1.2x trailing P/B. In ’08 it was 1x. General rule of thumb is market bottoms at 1x P/B for EM. Therefore by EV/EBITDA or P/B more downside left for EM equities
- On debt: Fed balance sheet expanded from $1T to $4.4T since QE began. This has led to EM FX reserves to grow $2.7T since beginning of QE. Monetary base up $3.6T. Lot of the expansion has gone to EM property markets, bond markets and some into equities.
- QE translated into EM primarily via debt markets. Corp bond issuance: +$1.4T, bank lending: +$1.3T i.e. total +$2.7 trillion over past 5 years. This is double the preceding 5-year period. (Therefore EV/EBITDA)
- EM earnings: just awful. Start of the year consensus has EM earnings +10-15% for the year but looking at last 4 years quite clear this is wishful thinking. EPS fell 3% in 2012, grew 1.2% in 2013, fell 8.2% last year. For 2015, consensus still has EPS growing 2-3% but this should turn –ve.
- EBIT margins: down to 9% vs 17% in 2006 (vs US where EBIT margins are at new highs near 13%). Therefore there is a reason EMs are cheap
- What to look at/what will turn the tide – 1)Turnaround in Chinese monetary conditions (referenced a BBG Monetary Conditions index for China here which closely tracks EMs in general and cyclicals in particularly). 2)A delay in a Fed rate hike will postpone the pain if nothing else. If they don’t do Sept then case can be made for a short-term tactical buy on EM equities 3)Valuation adjustment – EV/EBITDA needs to come down 6-6.5x. 3)A capitulation in sentiment on EMs. We may not be far away on this. 4)Pick-up in inflation, which again correlates well with EM equities
David Cui – China strategist. (warning: this one was a little *HELMETS ON* time)
- Continue to sell into any rallies on Chinese equities. Govt is struggling to hold the market up and will ultimately give up. (these comments were made yesterday afternoon. This story appeared late Asian hours today: http://bloom.bg/1ESXdL6 followed by the PBOC move on rates).
- A failure to stop an equity rout has significant implications for the market, the financial system and broader economy
- We’re a long way from the trough. Don’t buy till the Chinese govt panics. This could happen either via a massive QE program or physical stimulus. Even then rally will be short-lived unless coupled with large-scale bad debt write-off and a wholesale recap of the financial system + serious reforms
3 Key Points
1. Why govt is failing to stem the equity slide – valuations, leverage, reputation. Ex-banks, A-shares are trading at an average trailing P/E of 28x on rapidly deteriorating ‘E’. EV/EBITDA is even worse given debt.[Side point here: Median EV/EBITDA for A-shares at 21x, was 32x at peak. This is vs 11x in the U.S. and 8x in Japan. Even worse is the ROE. A-share ROEs are at 11%, & this juiced by significant leverage. Ex-leverage, one is looking at ROE’s of 7-8%, putting China only above Greece in terms of ROE. It is a terrible deal for the govt to keep buying A-shares
2. Cui estimates that about ~10T RMB worth of shares at least partially funded by leverage (this also lends credence to the fact that we’re still seeing margin trades unwinding in the A-share market). This is about ½ the free float. For margin financed positions to break even market needs to go higher. So unless the govt is willing to buy out a significant portion of the free float SHCOMP needs to drop to level that can be justified by fundamentals. This is roughly 40% below where it currently sits (!). If govt remains buyer of last resort as it has done over last few weeks it keeps denting reputation of the RMB.
3. When the dust settles the damage will be felt quite broadly. Financial services contributed 0.5 pct points to Q1 GDP. This can safely be written off. There will be –ve consequences on consumption. Net effect of the ups/downs on the A-share market has been a transfer of wealth from those in their 30s & 40s to the rich who managed to cash out. This will hurt future purchases of cars, mobile phones, tourism. This is not expected to be too severe though
4. Most importantly, & probably underappreciated by most is potential shock to the financial system (background: this has been Cui’s long-standing argument) – If A-shares continue their decline won’t be long before the equity base of brokers, trust cos & other shadow banking financial institutions is wiped out. Govt credibility has been hurt quite badly. 1st time in recent memory, Cui says, that there are doubts about govt’s ability to manage things smoothly
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What does the govt do next?
- PBOC to cut interest rates (Cui said once in Q3, happened today already), and 100 bps in RRRs through the year (50bps done today). Quicken infrastructure projects etc. This is not enough, govt is behind the curve.
- Risk of financial crisis breaking out is high and Cui says there are 2 options. Firstly, the Japanese way – more stimulus, take on private bad debts on its balance sheets. This would likely result in a sharp rebound followed a prolonged selloff. Not attractive. Secondly, the U.S. way. – write off significant portion of bad debts, recap the financial system. This will likely be met by a sharp selloff because of the dilution risk but if these steps are taken couple with reform then we can think about finding a genuine trough in the market.
Lastly a chart from me: