Get Long Taiwan

04/23/2019 1:18 pm EST


Landon Whaley

Editor, Gravitational Edge

Emerging markets appear to be on the cusp of a recovery, but for now stick with investments in Taiwan, like the dollar denominated FXI, writes Landon Whaley.

We were a bit early rolling out our “Emerging Market Resurgence” macro theme back on Feb. 4, which is why we put it back on the shelf in March’s macro theme updates. However, the recent data releases indicate that Q2 could be the bullish inflection point we’ve been anticipating but that the resurgence is going to be more nuanced than we originally thought. Rather than a wholesale recovery across emerging market economies, there will likely be a wide dispersion as some economies (Brazil for one) stay mired in Fundamental Gravity #3/4 environments and others begin to accelerate their way into equity-bullish Fundamental Gravity #1/2 scenarios.

Le Chinois

We deactivated our “Slowing Dragon” macro theme back on Feb. 4 after a profitable 16-month run of being opportunistically short Chinese equities. In that edition of Gravitational Edge, I said “The PBOC has stepped up on multiple occasions in the last few weeks and introduced various forms of liquidity into the system. The iShares China Large Cap ETF (FXI) has responded by ripping 9.4% higher to start the year and slicing through multiple Alpine lines like butter. The short Chinese equities trade was good to us during 2018, but now it’s as dead as disco.” We closed that macro theme just in time because since that publication, the Shanghai Composite index is up 24.1% and the U.S.-listed, dollar denominated, iShares China Large Cap ETF (FXI) has gained 7.0%.

As we know, markets often front run shifts in the underlying Fundamental Gravity, and last week’s deluge of March Chinese economic data is beginning to confirm the double digit gain in Chinese equities so far this year. When it comes to evaluating Chinese growth, we always begin with the Big 3: Retail sales, industrial production and fixed asset investment.

After slowing for the majority of 2018 and then flatlining at +8.2% for the last three months, retail sales got a huge shot in the arm during March, accelerating to an 8.7% annual growth rate. Similarly, industrial production growth began slowing at the beginning of 2018, flatlined at +5.3% for the last two months and then shot to +8.5% in March. And finally, fixed asset investment growth accelerated for the fifth time in the last eight months and is now sitting at the highest rate since last April. But it’s not just the big three confirming that a bottom may be in place. All of China’s PMI surveys, manufacturing and service (Caixin and government reported), are confirming the March acceleration off the January-February floor.

This data array confirms that the massive PBOC liquidity injection to start the year is beginning to hit its mark.

Given the length of the economic slowdown in China, the PBOC’s liquidity push, and the equity markets revival this year, it’s likely that China is undergoing a shift to a growth-accelerating regime for the first time since November 2017. That said, we only have one month of economic data confirming this shift, so we’ll tread carefully as we traverse the next few months.

The Trade

For a number of reasons, I wouldn’t invest a single shekel of risk capital in either China or Hong Kong. Luckily for us, there are a myriad of second derivative trades that benefit when China shifts from a Fundamental Gravity #3/4 environment to a risk asset-bullish Fundamental Gravity #1/2. Not surprisingly, one economy that benefits is Taiwan.

The equity market has already front run the coming shift, as the Taiwan Cap-Weighted Stock Index (TAIEX) is up 14.8% for the year and the U.S.-listed, greenback-denominated, iShares MSCI Taiwan ETF (EWT) is up a nearly identical 14.3%. It’s not just the price action that’s bullish; the Quantitative Gravity for EWT is as bullish as bodacious, and the Behavioral Gravity is telling us that investors remain bearish on this market, which is bullish for the long trade.

From a Fundamental Gravity perspective, inflation is low and Taiwan’s manufacturing PMI just accelerated for the first time in eight months. That said, we don’t get carbonated over one month of data and we need to see acceleration across a wide swath of Taiwanese indicators before we are convinced that Taiwan is putting its current FG #4 environment in the rear view. We are very interested in gaining exposure to Taiwanese equities over the balance of Q2.

The Bottom Line

We aren’t ready to activate the EM Resurgence macro theme until we see further Fundamental Gravity shifts from a few more key economies (like South Korea) as well as a deepening of the current shifts already taking place (like China). We’d also need to see a downside resolution to what we believe is a topping process in the U.S. dollar before we’d be full-bore ahead in the emerging market space. Until then, there is plenty of opportunity for us to trade our U.S. based macro themes …

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