In a commentary released on 9 September, Macquarie Equities Research (MER) addressed investor concerns regarding China’s declining competitiveness and also re-examined their own bullish case for emerging markets (including China) versus developed markets equities. Investors interested in MER’s views may wish to read on for excerpts from the report.

Unstoppable China – robust and persistent private sector productivity
Given rising costs, MER has re-assessed China’s competitiveness in the key manufacturing categories. Theoretically, declining competitiveness should come through in deteriorating external signals (such as revealed competitive advantage scores, market shares for products and components, and net trading balances). At the same time, one should see rising unit labour costs relative to China’s key trading partners. Does MER see the above signs from China’s international and domestic statistics?

The answer is largely in the negative. Although compensation costs are increasing (up by around 500% over the last decade), so is productivity. Hence, on a unit labour cost basis, China remains a cheaper and more efficient destination than almost any other EM or DM. MER estimates that currently China’s manufacturing unit labour costs are ~60% of the US levels and are lower than in Brazil, Mexico, Korea, Thailand, Malaysia or the Philippines. Indeed, amongst major EMs only India has a lower overall unit labour cost. It is China’s strong productivity; business clustering and migration up the value curve that is keeping China competitive, allowing it dominate 30% of global manufacturing.

The same message comes from international trade statistics, with China remaining highly competitive even in lower value-added manufacturing (such as textiles, clothing & footwear) whilst becoming fully integrated in most other sectors (such as machinery, telecom and office equipment). It is also climbing the value curve in electronics whilst becoming better in specialized niches (such as scientific equipment). The above trends are confirmed by a combination of revealed competitive advantage scores, market share and trade surplus trends. China has many structural issues but in MER’s view, external and domestic competitiveness is not one of them.

Emerging markets (EM) versus developed markets (DM) equities – is the game over?
Since late February 2014, MER has been suggesting that EM equities are likely to outperform DM. Indeed EM equities have outperformed by approximately 10% (US$ terms). The key drivers for a more bullish stance were compression of leading indicators (i.e. pick up in EM and slowdown in DM), oversold funds flow and low valuation multiples. In addition, the US$ remained relatively flat whilst the global cost of capital declined, in line with rising liquidity and high global savings rates. Are these trends about to change?

There are several indications that suggest that whilst EM relative performance might grind-out some further gains in coming months, the environment could change quickly. First, EM equities are no longer oversold. MER’s numbers indicate that funds flow to market capitalisation are now neutral (0.1% vs negative 0.5% in Mar’14). Second, the gap in leading indicators (EM vs DM) is closing. Third, whilst EM equities are still undervalued, the gap has narrowed by more than 100bps. Perhaps, most importantly, it seems that the US$ is attempting to break-out and currency volatilities have increased. At the same time, US rates have bounced from recent lows. Whilst MER does not believe that there will be a significant macro shift (in the next few months), volatilities could arrive quickly. MER is hedged by having the largest positive tilts in China, Korea and India.

Source: Macquarie Research - 11 Sep 2014