Top trades for 2019

We expect the coming stimulus to infrastructure spending in China to have a larger impact on domestic equities than in the EM aggregate. From 2015 to 2017, credit to households remained easy, which helped real estate, while credit to local governments tightened, which hurt infrastructure growth. Government statements are consistent with the stimulus shifting to infrastructure. Special local government bonds issuance, easier LGFV financing, and reduced scrutiny of PPP projects should lift infrastructure FAI to 10% y/y in 2019. Currently the spread between AA and AAA-rated local bonds – a good proxy for financial conditions – is close to the highest since 2015, suggesting local businesses are still suffering from the previous tightening of shadow liquidity (Figure 44). China's exports have stalled sequentially over the past three months, and new export orders PMI prints do not look inspiring. Whether because of tariffs or because of the tech boom plateauing, if the external sector slows further, the possibility of further easing from China will rise.

In an adverse scenario, we expect China to 'lean against the wind'

Our calculations show that while EM EPS growth is even more sensitive to China housing than it is to US or European capex, its beta to China infrastructure FAI is not statistically significant (Figure 45). The coming China stimulus will bring less help, but should still offer some for China, less for the rest of EM. In this environment, we recommend being long China A-shares, which have bigger exposure to traditional sectors of the economy that should benefit more from higher infrastructure expenditure in the coming months. We are long China A- shares vs MSCI EM ex China index (Bloomberg ticker: MXCXBRV Index).

China infrastructure FAI unlikely to have a significant impact on overall MSCI EM EPS

Figure 44: Liquidity conditions are tight; stimulus would be focused on infrastructure investment

Figure 45: EM EPS reaction to China's real estate investment is larger than to infrastructure

Average spread between 1y AA and AAA CNY bonds (bps)

180

TSF growth (% y/y, 3mma, rhs)

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2. Long MSCI EM Value vs MSCI EM Growth

EM Value outperformed EM Growth in 2018, but their relative index remains at the 12th percentile of its historical distribution since 1997 (Figure 46). In DM, this ratio is even more stretched, but the main arguments for being long EM Value vs EM Growth in 2019 is the difference in the sector composition of the two investment style indices.

EM equities' valuation discount to DM has widened further as the latter has been supported by the performance of the US market. But, it is largely EM Value sectors, such as materials, energy, financials and utilities that are cheap relative to DM. Growth-heavy sectors – consumer discretionary, consumer staples and healthcare –

Long-term underperformance and valuations should help to extend the recent EM Value rally

Growth-overweight sectors are expensive, and are seeing bigger earnings cuts vs Value sectors

Figure 46: MSCI EM and DM: Value/Growth relative indices

Figure 47: Percentile of current 12m fwd P/E relative to MSCI World (since 2002) vs 6m revisions in 12m fwd EPS

15Cheap and being upgraded

10

12m fPE relative to DM (percentile since 2002)

3. Long 10y Indian government bonds vs MSCI India

We expect India's growth to slow down in the second half of 2019. This deceleration will take a larger toll on equity valuations, while local bond markets are likely to benefit. We expect equity market total returns to depend on the external environment, domestic growth and the elections, but see returns as skewed towards 5–10% downside. For debt assets, we expect full-year returns of 9–10% (including c.25bp tightening in yields).

For the equity market, the spread between 10y G-Sec yields and earnings yields is high (Figure 48). Moreover, we do not see equity valuations as compelling because liquidity conditions are tighter and domestic retail flows into equity markets are slowing down, with risk from a reversal in these flows rising. For debt valuations, we expect annual inflation to average 4.6% in FY20, well within the RBI's target range, leading to a prolonged pause. This implies that in our valuation model we estimate 10y yields as currently 25bp too high as we see fair value at 7.25–7.50% (Figure 49). Market dynamics will also be supportive of local debt after the RBI's recent OMO purchases and potential slowdown in banks' credit growth (attributable to NBFC's liquidity squeeze), likely resulting in a modest pickup in their demand for G-Secs.

A deceleration in domestic growth will imply more de-rating for equities

Equity valuations have not adjusted enough to be attractive

We expect 25bp downside in G- Sec yields

Figure 48: Yawning gap between bond and earnings yield

Source: Bloomberg, Datastream, UBS

Figure 49: G-Secs are already pricing in a large risk-premia

Cheap (+)/Rich (-), RHS 10y (current)

Fair Value (dependant on CPI, IP, credit growth and short end rates)