Investors in Asian stocks need patience – until China economy and equities improve

GLOBAL markets rallied from the lows in June on hopes of a Federal Reserve pivot before correcting in mid-August. The correction was driven by the Fed’s message during the Jackson Hole meeting: Inflation is much more stubborn; US rates will go higher for longer; and no pivot on the horizon. The dollar continues to strengthen, which is a real headwind for Asian markets.

Similarly, in Europe, inflation levels far exceeded its central bank’s targets. The risk of further deterioration of energy supply threatens higher inflation ahead. The European Central Bank (ECB) lifted its interest rates by an unprecedented 75 basis points in its September meeting to curb inflation. Exceedingly high inflation in Europe and the risk of de-anchoring of inflation expectation are expected to force the ECB to raise interest rates more aggressively. The market is forecasting another unprecedented 75 basis-point hike in October.

Comparatively, the inflationary situation in Asia looks relatively moderate. Asian inflation is not demand driven but, rather, supply driven, and the labour market in contrast is weak, especially in China. Unlike in developed economies, there has been limited fiscal spending within Asia during the Covid-19 pandemic. Most Asian countries have not loosened all Covid measures yet, and demand has therefore been weak. However, the demand profile could change next year when Asian economies are fully opened.

Despite lower inflation, most Asian central banks hiked rates early, but not to the same degree as the West. The Bank of Japan (BOJ) and the People’s Bank of China (PBOC) are maintaining their neutral monetary policy stance to support the economy. Japan’s interest rate differential relative to the United States, lower growth and higher oil prices have put a lot of pressure on the Japanese Yen. Covid lockdowns and lower-than-expected growth forecast have also resulted in weakness in the Chinese yuan. The yuan recently has broken the level of 7 yuan (S$1.39) to the US dollar, and the PBOC has been working to dampen the effect.

Apac investment outlook

Asian markets still face many headwinds – weaker economies, particularly China; higher US rates; and a strong dollar. In the coming months, volatility and risk premium should remain elevated as US rates go higher and growth slows.

Equities

Asian equities, particularly North Asia, continue to underperform. Asian equities are now reasonably valued, but there are risks of earnings downgrades. In an environment where global equities are expected to generate only modest returns over the next year with increased volatility relative to the past, Asian equities have the potential for higher returns in the medium term. However, it is still too early to call an overweight on Asian equities relative to developed markets. The main constraint to Asian equities’ performance is the Chinese market. Unless we see an improvement in the Chinese economy and equity market, patience is needed.

Although China managed to recover quickly despite its zero-Covid policy in 2020, more lockdowns this year are really hurting consumer confidence; wage growth is low; and spending is weak. Another area of concern has been the Chinese property market. The central government is taking a more active role to help the property sector. However, the government could come up with more sustainable policy to address the deep-rooted issues and weak sentiment in the housing market.

The Chinese equity market has largely priced in the regulatory risks within the Internet space. Most regulatory changes have been announced and are in the implementation phase. Nevertheless, the Chinese Internet sector is still a consumer play and is negatively impacted by the weak consumer sentiment within China. A recovery in consumption is needed to lower the risk premium in the Internet sector. Other new economy areas have been held back by President Biden’s executive order on US Chips Act and Biotechnology and Biomanufacturing Innovation.

The Chinese equity market has largely priced in the negative economic environment and are over-sold, so downside could be limited. The US market is overpriced, and its outlook is weakening. Global risk-off and low positioning coupled with sufficient policy support provided by the Chinese government could see Chinese equities outperform tactically.

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India remains a key structural overweight with a good growth story. Investment cycle is picking up within India on the back of pent-up demand and an upturn in the residential property market. India is also more resilient, compared with the 2013 taper tantrum, with improved current account balances and foreign reserves. Tactically, when China’s growth outlook improves and equities rebound, Indian equities could underperform as investors rotate into the cyclical story in China.

Japanese equities offer good value with robust earnings. The increasing yield differential between the US and Japan is negative for the yen. However, the impact of a weaker yen on earnings has not been as great as in the past. Japan equities performance’s main constraints are weak consumer sentiment and a lack of domestic demand. Consumer sentiment remains almost as weak as during the global financial crisis in 2008. The service industries including the hospitality, dining and transportation sectors remain relatively weak. These sectors should improve as the country eases Covid restrictions and borders controls.

Asean equities continue to be well-placed to benefit from reopening, a revival of tourism and positive commodities prices. The key overweight remains Indonesian equities. Normalisation in domestic activity as the economy reopens, coupled with strong commodity-driven exports, and dovish monetary policy translated into relatively firmer headline growth. Covid also accelerated digitalisation which widens access to healthcare, education, and employment, as well as improved efficiency and services. A large e-commerce presence helped to increase the resilience of Indonesian small businesses during the Covid crisis.

Fixed income and currency

Asian credit, especially investment grade, continues to present attractive opportunities with higher saving rates, decent corporate balance sheets, and better-quality tilt against developed markets.

Within Asia credit, stay cautious on Chinese high-yield debt in the property market sector as there are little signs that the pressure on the sector is letting up. Unless more government support is provided for the housing market, it is too early to add positions in Chinese high-yield, despite the reasonable valuations. There are better opportunities outside Chinese credit – in India and Indonesia due to structural growth and positive commodity dynamics.

The writer is chief investment officer, APAC, and head of emerging markets, DWS.