Divergence to the fore - China and India on new paths

GROWTH is starting to stabilise in Asia, and we believe this stability should last for cyclical and structural reasons. Cyclically, we see signs of policy easing, with interest rates coming down now that inflation is less of a concern and asset prices in general having fallen. Lower commodity prices will also be helpful for Asia's inflation picture, as well as its current account deficits, given it is a net importer of most materials. In addition, exports have improved, particularly in the last six months, with global recovery seemingly more entrenched.

The bigger issue is what's happening from the structural perspective, notably in terms of reform. Reform has started to roll out across the whole of Asia, starting from China, but from the second quarter onwards we've also seen new regional governments such as those of India and Indonesia take on a fairly aggressive new path. Take for instance Indonesia, where we've finally seen the diesel price rise after many years of subsidies.

We believe that while these changes may have a negative effect in the short term, this will create a long-term opportunity for flexible, pragmatic investors in Asian equities. For instance, the long sought after crackdown on corruption is putting some downward pressure on growth, particularly in China, but also creating a more solid platform for higher quality growth going forward and, ultimately, better equity returns.

Value is hard to find these days, but we believe Asia is one of the few areas in the world that offer real opportunity for capital growth. For now, we are fairly neutral across style factors, having been transitioning towards value after being more growth-oriented in 2013. At the country level, our key overweight is India because of reform and a powerful combination of renewed economic momentum and falling inflation. We've also been increasing our exposure to South Korea, which has been a poor performer this year after a series of currency-driven earnings downgrades in its export sector. But the won is now weakening, at a time when the earnings outlook is stabilising and valuations in some of the more cyclical sectors are near crisis levels. Outside of those two positions, most of the risk we are taking is really at the stock level, in terms of idiosyncratic opportunities across markets, sectors and styles.

Interest rate sensitivity

In today's environment, one key area of concern is interest rate sensitivity. There are a number of stocks, sectors and even countries which are now highly correlated to movements in US bond prices. It is similar to a giant carry trade, with those stocks or sectors most obviously correlated with falling US rates now trading at their highest valuations ever relative to the rest of the market. We're also seeing much greater dispersion between returns from low-quality, cyclical stocks and their high quality, lower beta counterparts. The gap is now nearly as wide as it was at the height of the Asian crisis in 1998.

In China, what I found from recent research trips was pessimism - the long-mooted crackdown on corruption is having a deeper-than-expected impact on decision making, growth and, ultimately, valuations. It is a short-term cause for concern, but longer-term China still has plenty of weaponry in its policy arsenal - even after announcing its first rate cut for two years in late November. There's still more they could do - like adjusting reserve ratios in the banking sector downwards to add more liquidity to the system and ease some of the burden on corporate China, which is really where a lot of the debt sits. It's the fact that it has these options at its disposal that makes us believe that now is not necessarily the time to turn negative on China and we remain overweight the country.

I found the opposite in India, where optimism was widespread and real positivity is starting to show through in every corner of the economy. Prime Minister Narendra Modi and his Bharatiya Janata Party government have so far focused more on "micro" reforms. Initiatives such as labour reforms or his "Make in India" campaign for manufacturers, are already helping growth. He is also confronting corruption in a different way from China, largely by taking some of the incentives out of the system, rather than through punishment, which should free up capital.

Common market

We still expect to see some "big bang" reform, most probably in February's budget, likely focusing on the introduction of a harmonised Goods & Services Tax (GST). This should finally make India a true common market, not one fractured by myriad state and central government levies. It's not been easy to gain agreement on the GST, but it seems that the state governments have finally bought into the idea of a harmonised tax because they won't be worse off financially.

Firstly, some estimates suggest that the GST's introduction could actually increase GDP by about 2 per cent. Secondly, retailers typically have a distribution centre or a manufacturing facility in most Indian states because of how taxation laws work (goods that are sold across borders incur more tax), so if the tax is delivered as promised then such companies could reduce the need for regional distribution centres to just one or two. Working capital could reduce for many of these retailers by about 50 per cent as a result. As always, it's the effective implementation of legislation that counts - we wouldn't want to see the GST watered down with too many exceptions.

Overall, the key theme is one of divergence - China is relying on policy, particularly cyclical policy, to stabilise growth, whereas India is already enjoying the benefits of structural reforms. It is the first such divergence we've seen in a long time, and it's set to have very big implications for how we generate returns in Asia. In general, we expect a gradually healing global economy to help Asia, hence our preference for growth markets such as China and South Korea, and unique growth stories such as India, factoring in under ownership and cheap valuations.