China, India: Major Market Reversals Could Be At Hand

BMI View: We continue to call for strength in the Indian rupee and weakness in the Chinese yuan, while expecting weakness in the Indian Sensex and strength in the Shanghai Composite Index. This would mark a major reversal from the trends seen over recent months. Valuations, technicals, and the outlook for monetary policy all favour such a reversal.

When a country's economic fundamentals are improving, strength in its equity market tends to go hand in hand with currency appreciation, and vice versa. Broadly speaking, both rising equity prices and a stronger currency should reflect the increase in economic output that investors are discounting in the future. Although there are times when high inflation can undermine a currency but boost nominal equity performance, this is rare, as earnings multiple contraction usually outweighs any increase in nominal earnings expectations.

Episodes of currency weakness combined with equity strength, or equity weakness combined with currency strength, should be treated with caution, in our view. Rather than being a sign of uniform strength or weakness, it signals a divergence in outlooks for the two assets, which are highly likely to be corrected in a swift manner.

One Topping Pattern, One Basing Pattern
Indian Sensex Vs Shanghai Composite Index

China, India: Major Market Reversals Could Be At Hand

BMI View: We continue to call for strength in the Indian rupee and weakness in the Chinese yuan, while expecting weakness in the Indian Sensex and strength in the Shanghai Composite Index. This would mark a major reversal from the trends seen over recent months. Valuations, technicals, and the outlook for monetary policy all favour such a reversal.

When a country's economic fundamentals are improving, strength in its equity market tends to go hand in hand with currency appreciation, and vice versa. Broadly speaking, both rising equity prices and a stronger currency should reflect the increase in economic output that investors are discounting in the future. Although there are times when high inflation can undermine a currency but boost nominal equity performance, this is rare, as earnings multiple contraction usually outweighs any increase in nominal earnings expectations.

Episodes of currency weakness combined with equity strength, or equity weakness combined with currency strength, should be treated with caution, in our view. Rather than being a sign of uniform strength or weakness, it signals a divergence in outlooks for the two assets, which are highly likely to be corrected in a swift manner.

We recently wrote on the potential for a reversal in trends in China and India, due in part to our expectations for policy action, and in part because of extreme divergences in valuations. Namely, we are bullish towards Chinese equities and bearish towards the yuan, yet we are bullish towards the rupee and bearish towards Indian equities.

What Explains Current Extremes?

Could a weakening INR be boosting earnings and/or a strengthening CNY be hurting earnings?

This has not been the case thus far. The outperformance of the Sensex over the Shanghai Composite Index (SCI) has been entirely down to multiple expansion in the former and contraction in the latter. Nominal earnings have actually outperformed in China since the start of the year.

Could a weakening INR be boosting earnings expectations and/or strengthening CNY be hurting earnings expectations?

While this is possible, we see it as unlikely. Neither stock market has a great deal of exposure to export earnings, both being dominated by local players, primarily banks. On balance, currency dynamics should undermine the earnings outlook in India, while improving the earnings outlook in China, all else being equal. Indeed, even in the case of the exporters, a weakening INR would at best give exporters a one-off earnings boost, which would likely be given back at a later date once input costs rise in line with export prices.

Are equity markets mean reverting after a period of relatively expensive Chinese equities and a cheap yuan?

Again, this does not appear to be the case. Looking at real effective exchange rate data, the yuan has been appreciating against the rupee for years, and is near all-time highs relatively. Meanwhile, the Sensex trades at almost twice as expensive as the SCI on most valuation metrics.

Technicals Point To A Reversal

With Chinese equities trading at an extreme discount relative to their Indian counterparts, and the yuan trading at an all-time high versus the rupee, we believe the risks heavily favour some form of reversal in these counterintuitive trends. The technical patterns seem to strongly support such a reversal.

One Topping Pattern, One Basing Pattern
Indian Sensex Vs Shanghai Composite Index

The Sensex appears to be struggling to break through its recent high, tracing out what could be a triple top formation. On the other hand, the SCI has held support and, together with similarly bullish pattern in H-shares market ( see 'Regional Equity Strategy', July 23), looks set to strengthen over the coming weeks.

INR Testing Resistance, CNY Breaking Support
INR/US$ And Chinese Yuan 12-Month Non-Deliverable Forward Outright

The INR is looking primed for a reversal after posting a series of bullish RSI divergence signals over recent weeks and months. A break through short-term resistance would be a very positive move. Meanwhile, the Chinese 12-month NDF is looking weak. After breaking through short-term support, the stage could be set for an inverse head-and-shoulders pattern to play out.

Policy Is Turning In Our Favour

Not only do valuations and technicals favour a reversal of recent trends, but policymakers are likely to become supportive too. We believe that the Reserve Bank of India (RBI)'s decision making process over the coming months will centre around the country's fragile external dynamics, specifically the stability of the rupee, which for us means a continued pause in its current easing cycle. The recent steep increase in swap rates bolsters our outlook that the repo rate will remain at 7.25% this fiscal year - a view that remains very much above market expectations at this point in time. This will act as a drag on the Sensex while supporting a stabilisation in the rupee. In the case of China, one policy option that we believe Beijing will draw upon over the coming months is steering the yuan weaker. In the face of a growing deflationary threat, a weak export picture, and a rapid loss of competitiveness, this seems highly likely, in our view. This would help to calm deflation fears that seem to be priced into local equities.

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