In a world a bit short on growth, the Chinese secular growth story in recent years – particularly in the consumer space – has delivered returns that were largely justified by the innovative business models that delivered them. When stock fundamentals start going soft, however, as they did this year in the China Consumer Discretionary sector, price momentum on its own represents a danger signal. This high-flying sector, stuffed full of mega-cap names, is off nearly 20% YTD.1
Consensus to Crowded to Dangerous
Toward the second half of 2020, China stock prices were rising, and the earnings base was at least stable – which was seen as tolerable in a pandemic economy. While some may have quibbled with the valuations at that time, investors at least had to respect the earnings delivery – they continued to crowd into this trade. But, as we got into early 2021, the divergence of stock prices and EPS estimates began to flash a clear warning sign in our AQE models (see Figure 1). Despite the divergence, for several months prices continued to power upward even as earnings began to wobble. By the end of Q1, the earnings wobble had become a waterslide – and had begun to do some real damage.
Figure 1 : Decoupling Leads to Dramatic Price Action
As quantitative investors, our work is heavily focused on keeping a balance between the various elements that drive markets. We use price momentum, but we want it to be supported by earnings. Even though value is an anchor in our process, we happily buy growth names if they are justified by profitability. If fundamentals start to fade, our signals tell us to adjust our positioning – and we are nimble in doing so.
At the beginning of the year our alpha scores had turned neutral or negative on these high-flying China Consumer Discretionary names in virtually every component, and we successfully averted losses to our portfolios. Indeed, our preferred stocks this year in the consumer space (autos, sports apparel, robotics) generally managed to avoid the selling pressure, leading to very strong overall portfolio outcomes (see Figure 2).
Figure 2 : AQE Alpha in the China Consumer Discretionary Sector
We claim no great regulatory predictive power. That said, however, we believe that any equity valuation should reflect some degree of regulatory risk – especially in emerging markets, where there may be limited legal or legislative review of regulatory actions. Diversification is the EM investor’s best friend here, and is a key tenet of AQE portfolio construction.
Our lack of precise foresight also extends to determining an entry point in a depressed China equity market. We don’t yet see a balance between better valuation and supportive fundamentals, and the price action in our momentum signals suggests the risk environment has not stabilized. Patience is usually rewarded, even if you miss the first leg of a rebound
What We Do Like in Emerging Markets
In terms of country allocation, we are slightly below benchmark in China. Our overweight markets are mainly the other Asian heavyweights, Korea (where we like the Consumer names) and Taiwan (IT and Financials), but we have also built up a solid position in Russia (Banks and Steel). In China, we like the Pharma companies and the Energy names (plus some Apparel and Auto Retailers within the discretionary sector).
1YTD as of July 31, 2021. MSCI China is down 13%; MSCI Emerging Markets ex China is up almost 10%; and MSCI World is up 15%.
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