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Global Top Cat

The Market Investors Love to Hate

By Yiannis G. Mostrous, on Jun. 8, 2017

Editor’s Note: This Global Top Cat article originally appeared for Capitalist Times Premium readers in late February. Since then, the specific stocks noted in the original article are up 10 percent, as subscribers know. If you aren’t a subscriber yet, it’s not too late!

The MSCI Asia Ex Japan Index has enjoyed its best start since 2012, up 10.2 percent this year. China’s stock market has emerged as one of the best performers, with MSCI China Index gaining 11.6 percent. Although pullbacks are to be expected, investors are in for a good year and should buy the dips.

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(Click to enlarge.)

China finished celebrating the year of the Rooster. The last time China celebrated the year of the Rooster was 2005, when the MSCI Asia Ex Japan Index appreciated by 23 percent. India, South Korea and China were the top performers, and India (A True Friend) and China will do so again.

China is the stock market investors love to hate. The conversations are always about what could go wrong in China and rarely what could, or will, go right. And yet China’s equities have outperformed emerging markets during the past one-, three- and five-year periods. That five-year stretch beat other markets by double digits.

Most investors question the sustainability of the rally in Asia. Many of these skeptics are not invested in the region, at least not substantially. The ones who are mainly own names in defensive sectors, such as consumer staples, health care and consumer discretionary.

For the past year, we’ve made the case that cyclicals and growth names should be the focus when investing in Asia, in general, and China, in particular. The rational has been a simple one: Asia and China were starting to recover, and growth and cyclicality offered the best opportunity, especially when valuations were relatively low.

The only factor that has changed is that stocks are no longer trading at such deep discounts. That said, the consensus expectation calls for earnings to grow by roughly 15 percent for 2017.

At the same time, central banks around the world have continued accommodative monetary policies. This includes the Federal Reserve, which indicated it will take its time increasing interest rates because there are too many macro uncertainties. Expect the Fed to hike rates twice this year.

One China

Asian economies continue to evolve rapidly, even though their growth rate has slowed. The biggest change is the move toward consumption and services.

In China, growth in services overtook the industrial part of the economy five years ago. Last year, consumption contributed almost 65 percent to the increase in China’s gross domestic product (GDP). Only ten years ago, this segment accounted for a little more than 40 percent of the economy.

Despite the occasional policy misstep or communication mistake from Beijing, China’s economic outlook should remain sanguine. This is in stark contrast to what you’ll hear from the many Western commentators who warn of imminent collapse–just as they have for the past decade and a half.

China should again account for 30 percent of global economic growth. And there won’t be a hard landing this year as the economy continues to transition to services.

This shift may slow economic growth, which is still strong at between 6 to 7 percent, and result in increased volatility. The Chinese government’s goal is clear: Policymakers will do everything they can to achieve it. Expect them to do so.

China’s debt levels remain a concern for investors. Policymakers in Beijing are aware of this challenge and have the necessary tools to manage the issue. Investors should give the government the benefit of the doubt when it comes to managing the economy.

Unfortunately, most investors assume the worst about China until proven otherwise. This herd mentality leads to stampedes in and out of Chinese equities, with little regard for the economy’s long-term promise.

The data supports the notion that policymakers know what they are doing: New corporate loans declined 20 percent from year-ago levels in January. And businesses seem to finally be de-leveraging. March’s release from the Bank of International Settlements (BIS) should show an improved debt-to-GDP ratio.

On the growth side, fixed asset investment (FAI) should surprise investors, with manufacturing leading the way. This metric started to turn for the better toward the end of 2016 and should continue to improve. Property (relatively low inventory levels) and infrastructure (bank lending) FAIs should also be resilient this year.

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(Click to enlarge.)

Continue to allocate capital to Chinese equities, but keep in mind the certainty of corrections during a strong market and potential consequences of geopolitical developments. We prefer the financial and technology sectors.

In the financial sector, banks, insurance companies and brokers have positive momentum, good valuations and specific upside catalysts–improving profitability, progress on bond issuance and initial public offerings, and upward earnings revisions. If you’re a subscriber, read the original article for specific investment ideas.

Yiannis G. Mostrous contributes his expertise in emerging markets and international equities to Capitalist Times in his Global Top Cat columns.

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