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BAML’s EM bull call: Don’t fight China trend

Customers and realtors look at building models at an exhibition in Jiashan in East China.
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Bank of America Merrill Lynch this week reversed its five-year long negative view on emerging markets, partly based on its view of a stabilizing China and not fighting that country's central bank.

"We are at an inflection point that is likely to challenge the winners of the past five years and boost the losers," Ajay Singh Kapur, an equity strategist at the firm, said in a Sunday note that outlined the case for becoming "structurally bullish."

BofAML turned tactically bullish on the Asia ex-Japan and EM equities at the end of February based on a better outlook on U.S. and emerging market economic growth, and easy Chinese monetary policy. Now Kapur sees that easing gaining traction, particularly in rising property prices.

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"Monetary policy in China is working exactly as it should — by boosting property prices (a USD 22 trillion market, accounting for 57 percent of Chinese household wealth)," he said in the report. "Imposing negative real deposit rates of -0.8 percent on China's savers to financially repress them makes sense given China's 250 percent nonfinancial sector debt to GDP. Don't fight this."

The average new home price in 70 major Chinese cities rose 4.9 percent in March from a year ago, after climbing 4.6 percent in February, according to Reuters calculations based on data released by the National Bureau of Statistics on Monday. Although fears of overheating in some cities have prompted fresh rules for buyers, the overall rise in prices extends the recovery in China's housing market from its bottom last year.

Outside of China, Kapur recommends overweight exposure in Taiwan, Australia, Indonesia, Russia, Turkey and Chile.

"Growth/defensives sectors — The staples, Health care, Utilities, Telecoms, Internet/software sub-(SHUT-I) sectors have outperformed cyclicals by 35 percent in EMs since 2011 as the USD strengthened and inflation fell," he said in the note. "Time to reverse this. Buy EMs/Asia ex-Japan cyclicals/value and sell SHUT-I."

In addition to Chinese monetary policy, other factors Kapur cites for include:

  • Cheap share valuation — Asian price to sales relative to the world is in the 17th cheapest percentile since 1995; EM is in the 19th.
  • Historically low positioning among fund managers — EM is 1.1 standard deviations below the average exposure, according to BofAML's April fund managers survey.
  • Stabilization in the U.S. dollar and greater competitiveness in Asia/EM currencies — 40 percent of the 23 markets fell to their most competitive quartile this year.
  • Recovery in Asian/EM earnings — A larger U.S. current account deficit, more competitive Asia/EM currencies and more controlled capital expenditures will help boost profit margins in the Asia/EM region.
  • Pressure for reform in state-owned enterprises will increase efficiency and margins.

"If they (Chinese authorities) muddle through these well-known 'structural' issues, while maintaining an easy policy that massages the tough transition to a services-driven, slower economy, we think the tail risks would be overestimated," Kapur said.

In its most aggressive easing policy since the global financial crisis, the People's Bank of China has cut interest rates six times since late 2014 and reduced the reserve requirement five times.

To be sure, the direct connection between Chinese monetary policy, the property market and equity performance remains unclear.

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Real estate companies make up just 5 percent of total A-share market capitalization, according to Wind Information.

In addition, Clem Miller, portfolio manager at Wilmington Trust Investment Advisors, said real estate stocks have actually been a detractor from equity returns so far this year.

"So, I wouldn't agree that monetary policy has gained traction. It might still do so, but it hasn't begun to yet," he said in an email, noting the major equity contributors year to date have been firms in oil and gas, and the internet sector.

Other risks, BofAML notes, to its bullish view on EM include unexpected strengthening in the U.S. dollar, a global recession and lack of reform in state-owned enterprises.

While the short emerging market trade is still among the top crowded trades, according to BofAML's April fund managers survey, fund flows and analyst comments indicate sentiment is beginning to shift.

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Peter Boockvar, chief market analyst at The Lindsey Group, is positive on emerging markets but for different reasons than the BofAML note.

"I think emerging markets are going to be bottoming with the bottoming in commodity prices and the topping out in the U.S. dollar," he said.

The U.S. dollar index has fallen more than 4.5 percent so far this year and will likely remain subdued as expectations for the next Fed rate hike are increasingly pushed out.

If that forecast holds, EM's recent outperformance could continue.

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The iShares MSCI Emerging Markets ETF (EEM) is up more than 9 percent year to date after falling in 4 out of the last 5 years. In contrast, the is up more than 2.5 percent for the year so far while the German DAX is more than 3.5 percent lower and the Nikkei 225 off more than 11 percent, tracking for its first negative year since 2011.

Reuters contributed to this report.