20 December 2018
What a difference a year makes! At the end of 2017, against a backdrop of sanguine economic conditions, reacceleration of global trade, and healthy profit growth, the MSCI All Country Asia ex Japan Index was well on its way to all-time highs. Fast-forward 12 months, and the same index has declined 14% from its January peak to November and sentiment has turned decidedly more negative. So, the question to ask is, how did things change so quickly? A combination of events, which we find can simply be summarized by a stronger United States and weaker China, have contributed to a weaker year for Asian equities. We explore some of these points below.
China’s deliberate deleveraging
The impact of China’s latest deleveraging campaign, initiated in late 2016, is being felt in the economy, with key indicators such as credit growth and Purchasing Managers’ Indices (PMIs) showing clear signs of slowing in recent quarters (source: CEIC Data). While this outcome was deliberately engineered by the nation’s policymakers in their bid to derisk the financial system, in particular off-balance sheet lending as seen in the chart below, investors are nervous about its negative impact on the property market, a major driver of the country’s economic activity, and its spillover effects on consumer sentiment. With so much of the fortunes of the region tied to China’s continued prosperity, we’re not surprised that attitudes toward Asian stocks have been far more subdued and cautious.
Off-balance sheet lending drives Total Social Financing lower
Source: CEIC, Macquarie Macro Strategy, as of December 2018.
Trade wars escalating
With the Chinese economy already decelerating, the escalation of the trade war with the US further exacerbates the risks and uncertainty the region faces. Even though domestic consumption is now a far greater driver of growth in Asia than in the past, the US remains a significant source of end-demand for the region’s exports, and the imposition of tariffs weighs further on the region’s prospects. However, for all the pessimism around this issue, the meetings and the resulting temporary “trade truce” between the two countries at the G20 summit in Buenos Aires in early December offer hope that both sides are taking each other’s grievances seriously and are working together toward more constructive mutually acceptable outcomes.
Currency and oil
Emerging market economies have been squeezed by a stronger US dollar and, for Asian economies more specifically, higher energy prices. Although energy has seen dramatic price drops recently, this caution toward emerging markets is most clearly reflected, in our view, in the sustained depreciation of a number of currencies, especially in Turkey and Argentina, whose currencies have lost 28% and 51% respectively against the US dollar over the year to November 2018. In comparison, developing Asian currencies depreciated by an average of 5.3% over the same period (marginally better than even the euro), which we think is a recognition of the region’s resilience. (Sources: Bloomberg.)
Factors leading to performance
The combination of aspects such as trade, energy, and currencies, in addition to tighter monetary conditions globally and a general caution toward emerging markets, have been factors in Asia’s underperforming relative to its developed market peers in 2018. Often favored for their growth dynamics, Asian stocks have also fallen out of favor as lower global growth expectations translate to lower earnings expectations, especially among the more cyclical export sectors.
Despite all the negative sentiment and pressure on the region’s exports, the structural growth in Asia demonstrated its resilience as earnings grew in 2018 and hence the region’s weak performance was driven by a large derating of valuation multiples. The chart below shows the magnitude of price-to-earnings (P/E) contraction and its contribution to the overall return, which was most severely felt in China as investors fear upcoming earnings downgrades.
Contribution to Asia ex Japan's total return in 2018
Source: MSCI, CLSA, Factset, as of 7 November 2018
Uncertain outlook can bring opportunities
It is said that uncertainty breeds opportunity. So, while the outlook for 2019 is a murky one and plenty of questions are unanswered, we also believe that these kinds of environments favor stock-pickers and active management.
Our starting assumption for 2019 is that market volatility will likely remain at heightened levels. Following 10 years of expansion, the US economy is now at an inflection point — just as economic momentum was riding high, the US Federal Reserve reasserted its continued willingness to adjust its monetary policy to prevent the economy from overheating. On the other side of the Pacific Ocean, China faces the opposite situation as its economy slows and policymakers weigh their support options. The crosswinds of these opposing forces will create market volatility as investors grapple for clarity.
Watching for political risks
In a similar vein, markets are driven more and more by political developments, and 2019 is not without its risks on this front. While observers are keenly watching for signs of intervention from Chinese policymakers, particularly for fiscal stimulus, headlines will likely focus on trade negotiations between China and the US. We should also be cognizant of general elections in India and Indonesia, the second and fourth largest Asia ex Japan economies. Current expectations are for the status quo to be maintained, but as we learned from 2016, contemporary politics can indeed surprise. For the observant investor, these surprises can be a source of opportunity, and active management means we can be selective about the risks the portfolio is exposed to.
In many ways, the negativity toward Asia equities this year has resulted in cases of the “baby being thrown out with the bathwater.” For example, valuations for quality stocks in Asia are now trading at discounts to their international peers not seen in the past 12 years, as illustrated in the chart below. In these times of higher volatility, we believe an active, bottom-up stock-picking strategy can take advantage of selloffs to acquire attractive companies at compelling valuations.
While the above events have an impact, 2018 showed the structural growth in Asian economies, and the earnings prospects of those tied to domestic demand, are resilient and enduring. As we enter 2019, some of the lag effects of these events will naturally impact the performance of some Asian companies, more specifically in the cyclical export sectors. Nonetheless, we expect corporate earnings and economic growth to endure at respectable rates. The key difference in Asian markets between 2018 and 2019 are valuation multiples.
Valuations of Asian quality stocks at 12-year low
MSCI AC Asia ex Japan relative to MSCI All Country World Index, top quintile ROIC, relative P/E
Source: MSCI, CLSA, FactSet.
This chart illustrates the top quintile of the most profitable companies, as measured by return on invested capital (ROIC), and the relative P/E of Asian companies compared to the rest of the world. Therefore, the Asian stocks plotting above 1.00 are more expensive; those below 1.00 are cheaper.
||MSCI country net total return (YTD as of November 2018)
||Economy slowed and risks heightened by trade wars. Investors are also more cautious following a number of surprise government interventions in various industries such as labor, tax reform, and pharmaceutical regulatory crackdowns. Monetary policy has seen rates drop with availability of capital easing. Nonetheless, structural impediments to private sector lending have not seen this support the economy.
||We anticipate 2019 will be a battle between trade policy and stimulus. Trade policy has seen a pull forward of demand in mid-2018, followed by a destocking in late 2018, which will likely extend into the first half of 2019. Thereafter, the impact is dependent on whether the trade war abates or is escalated. Further stimulus has been widely touted and may include relaxations in deleveraging policy, tax reform, market reforms, infrastructure investment plans, and loosening property restrictions.
||Tighter monetary conditions are finally being felt in the housing market, with property prices under pressure through a tightening of lending standards and banks lowering property valuations.
||Caught in a tough place with a weakening property market weighing on local consumer sentiment, and Chinese tourism slowing as Chinese consumers tighten their wallets amid economic uncertainty. However, the Hong Kong Special Administrative Region (HKSAR) government has lots of room to ease if required.
||Weaker iPhone shipments, reduced demand for capital expenditures (capex), and slowing of global trade meant that Taiwan’s economic growth moderated in 2018.
||As an economy quite dependent on external conditions, its fortunes are also tied to factors that are largely out of its control. Still, its gross domestic product (GDP) is forecast to grow in the 2% range in 2019.
||Domestic economic conditions remain subdued with investors critical of the government’s handling of the economy, but improved relations with North Korea have reduced geopolitical risks.
||Much like Taiwan, the Korean economy is highly export oriented and much will depend on whether external conditions improve in 2019. However, investors are likely to be hopeful that the government takes a more business-friendly position and will look for signs of a revival in private investment.
||Sentiment has been weak as investors fear the country’s twin-deficit status in the face of a stronger US dollar and rising energy prices. Investor confidence was also rocked by the failure of major lender, Infrastructure Leasing & Financial Services Limited (IL&FS), and the fallout of its default to the financial system. Nevertheless, India’s diversity and low base have seen its economy grow above 7% despite these challenges.
||As a country that is dependent on energy-imports, the recent retreat of oil prices should take some pressure off the economy. All eyes will be on the 2019 general elections; consensus expectations favor the incumbent Prime Minister Narendra Modi, but his majority government may be vulnerable. With these balancing factors, the outlook is for similar structural growth in the range of 7%.
||In a year where fear has driven returns in emerging markets, Thailand has been a relative island of calm due to its lower export exposure and external liabilities. Improvements to its private investments have also helped Thai equities be the strongest-performing market this year.
||With China’s economy entering a more uncertain phase, concerns are growing over the health of Chinese tourist arrivals in 2019. Should domestic conditions materially worsen, investors may expect fiscal support, particularly in the area of infrastructure spending. A general election has been planned in the first half of 2019 to reinstate a civilian government after several years of military rule.
||Steady-as-she-goes in 2018 for Singapore, with the city-nation’s GDP on track to grow 3%. Macroeconomic risk management, primarily cooling the housing market, was the government’s policy priority.
||Singapore is a very open economy and its 2019 GDP growth is expected to edge down a little to 2.6% as a result of the downturn in global trade conditions. Yet domestic conditions are stable and the Monetary Authority of Singapore (MAS) has room to ease if required.
||As a twin-deficit country, Indonesia’s resilience was tested against a stronger dollar and higher energy. Following the central bank’s four interest rate hikes in 2018, attention was largely focused on managing macroeconomic risks.
||While a recent reversal of energy prices will certainly take some pressure off the economy, we expect the policy direction will bias stability over growth in the foreseeable future and so a meaningful reacceleration in 2019 is unlikely. However, increased spending ahead of the general election will be slightly positive for growth, in our view.
||The Malaysian election delivered a surprise victory for the opposition Pakatan Harapan party. Promising a populist agenda, the new government quickly removed the country’s unpopular goods and services tax (GST) and cancelled or placed a number of large-scale infrastructure projects on review for cost and national interest concerns.
||The country is forecast to grow its GDP by more than 4% in 2019, but this will be predicated by the resumption of major infrastructure projects and consumption holding its ground.
||The year 2018 saw inflation surprise the market and central bankers reacting late but decisively in raising policy rates by 1.75%. The main impact of the rate increases was to slow capital investment. The effect on consumer sentiment was less, whereas property investment was barely affected. As the year concludes, inflation appears tame.
||Under current economic conditions, GDP growth is expected to remain robust at 6% to 6.5%, but not matching the 6.7% pace of recent years in the absence of meaningful private sector capital investment. Policy bias is looking neutral in the face of falling inflation, but will remain data dependent.
Source: Bloomberg. Net total return figures are in US dollars and based on MSCI indices for individual countries. All GDP growth estimates and comments are derived from J.P. Morgan.