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Eyes on Asia
The Asia ex-Japan region outperformed other major equities markets in 2017 with a return of over 37 per cent. The big question is whether such robust returns can be sustained, and how investors should approach the region in 2018, particularly as volatility has ratcheted up. Our experts share their views.
The Business Times' Wealth Roundtable
Genevieve Cua, BT Wealth Editor poses questions to wealth experts for their insights on Asia ex-Japan assets.
Deepak Khanna is Head of Wealth Development, HSBC Bank (Singapore) Limited. Deepak is responsible for the HSBC Bank's wealth business including the overall product and services roadmap, customer insights and governance. He enjoys playing squash and riding, and is passionate about painting.
Irene Goh is Head of Multi Asset Solutions - Asia Pacifi c, Aberdeen Standard Investments. Irene is responsible for managing multi-asset portfolios in Asia Pacifi c. She is an enthusiast of coloured gems.
Jeffrey Roskell, Managing Director, JP Morgan Asset Management. Jeffrey is a Portfolio Manager and Head of the Income Strategy within the Emerging Markets and Asia Pacifi c (EMAP) Equities team, based in Hong Kong. He enjoys spending time with his children and loves all sports, in particular golf.
What is your outlook for Asia ex-Japan equity and debt markets in 2018? What are the major drivers underlying your view?
Deepak Khanna: The main investment opportunities we see for 2018 in global equity markets are in Asia, and especially North-Asian markets like South Korea, Taiwan, and China itself. Asia is geared to continue growing this year, which will benefi t Asian equities.
Within the credit markets, we prefer emerging market bonds, in particular Asian bonds that are denominated in their local currency, rather than USD. We believe their medium-term performance will be positive on the back of economic growth, low infl ation, and additional factors such as improving commodity prices and brisk international trade.
In addition, interest rates have remained lower than expected, for much longer than anticipated, which further supports risk assets such as equities.
Growth continues to accelerate across emerging markets and despite many concerns, has not been derailed. Growth remains strong in China and India. Many Asian countries, having undergone several years of reforms, are also in a better position to withstand any surprise rise in the US dollar.
As a result, Asia ex-Japan equities have now had 19 consecutive months of earnings upgrades. Earnings and the earnings outlook have been improving for a range of reasons including the synchronised global growth, removal of excess capacity in many market segments, improved balance sheet management and Asian companies moving into higher value goods and services.
Irene Goh: Asia is in rude health. We believe the pick-up in global trade will continue to drive growth, earnings, equity markets and currencies across the region's emerging markets. We don't anticipate major disruption from the rate-rising cycle and withdrawal of stimulus in the US and Europe, where policymakers are taking a gradual approach. In fact, we see longer-term benefi ts as rate normalisation helps to curb asset-price distortion following years of quantitative easing. The recent stock market pull-backs are a reminder of how hard equities had rallied as return-hungry investors chased growth, especially among technology names. We wouldn't be surprised to see increased volatility this year but company fundamentals appear sound, with earnings driven by improving sales and margins.
Consensus estimates put growth in earnings per share for Asia ex-Japan at 12-15 per cent for 2018. While valuations are higher than in the recent past, a price-to-earnings ratio of around 16 times seems reasonable in light of good earnings prospects. Asian equity markets still trade at a discount to developed markets. Still, we expect more moderate returns in 2018 after last year's stellar gains.
We are positive, too, on the outlook for Asia's local currency bond markets, with infl ation still relatively well-behaved and borrowing needs underpinned by rising consumption, infrastructure investment and economic growth. We expect improved fundamentals - low government debt, growing foreign exchange reserves and a stronger balance of payments - to continue driving returns across most local currency emerging bond markets in 2018.
Sound fundamentals are helping to maintain lower volatility among Asian currencies. It was noticeable how the recent bond market correction was less pronounced in Asia than in most developed markets - a good indicator of the region's resilience. We expect high-yielding local currency markets such as India and Indonesia to continue attracting global investor interest. Local and hard currency credit issuance is increasingly deep and diverse in Asia. We think hard-currency issuance in the region will continue to be led by China, where companies will need to tap dollar funding amid deleveraging and tight credit conditions at home.
Jeffrey Roskell: We are broadly positive on the outlook for Asian assets. Over the longer term we are fi rm believers in this being the "Asian Century", with economic growth supporting an expanding middle class of consumers. Equally important, in aggregate we believe corporate governance is improving - albeit with the necessity for investors to remain very selective.
Over the near term we think that the global economy offers a supportive backdrop for Asian equities in 2018. They sit close to longer term average historical valuations and are exhibiting positive earnings growth momentum. This is an environment which we would ordinarily expect to produce equity returns of high single digits or higher - not as exciting as 2017, perhaps, but nevertheless very respectable!
For Asian credit we would expect to see potentially 3-4 per cent total returns. In other words, in line with current yields, in the absence of meaningful moves in interest rates.
What do you see as the most promising investment themes for Asia ex-Japan over the near and medium term? What regions and/or sectors do you favour?
Deepak: While we are not thematic investors, we see some major opportunities.
In China, for instance, solid earnings growth, ROE recovery, corporate innovation and an overall stable macro-environment are supportive of our views. With stability remaining a priority for China, the focus on financial-risk prevention (regulatory overhaul and deleveraging, etc), supply-side reforms and environmental protection will ensure quality growth that will support Chinese equities in the medium term. Other potential catalysts that will further support Chinese equities' mediumterm growth are the A-shares' inclusion into the MSCI and other market-oriented financial reforms.
Similarly for India, a gradual cyclical recovery is helping to revive corporate earnings, as reforms implemented (eg GST) should start paying off after short-term disruptions. Improved margins, high asset turnover and ROE cycle trending upwards all bode well for Indian equities.
The public sector bank recapitalisation plan should further help accelerate the NPA (non-performing assets) resolution process, enable more effective policy transmission, and improve the prospect of a credit recovery. The government's budget focus on rural/agriculture - mostly on productivity enhancement schemes - is also positive for the relevant sectors.
For Singapore, a trade-led economic recovery coupled with a pick-up in private consumption along with a firmer labour market and a revival in the property and credit cycles supports corporate earnings and ROE, amid productivity gains in some sectors. Bank asset quality has also stabilised. The 2018 budget is moderately expansionary, with the deferment of a 2 per cent GST hike to 2021 at the earliest which is a relief and a consumption-supportive measure. High dividend yield remains a positive draw for investors.
As for Asian fixed income, from a near-term perspective, this asset class is sensitive to US monetary policy. Whilst a gradual interest rate hike cycle in the US is positive for the asset class, Asian bond spreads look particularly tight (162bp for the EMBI Global Asia as at 28 February) compared to other regions within the EM space (415bp for the EMBI Global Latin America for example), which reduces their relative attractiveness in the near to medium term.
Irene: We believe that expanding populations and rising wealth will drive structural growth in domestic consumption across Asia, particularly in South-east Asia and India. We invest in firms that are expected to benefit, which explains why our portfolio is heavily exposed to consumer staple stocks that deal in everyday essentials such as food, beverages and household goods.
We also favour firms that benefit from consumption indirectly, such as banks. But quality consumer staples don't come cheap, so investors need to remain disciplined on valuations. We also anticipate structural demand for healthcare, where we focus on companies best placed to adapt to policy and regulatory changes.
Separately, disruptive trends such as autonomous driving, electrification and digital interconnectivity are driving demand for semiconductor chips and parts.
We have been raising our weighting on companies in this sector, where matching growth expectations against valuations is important. Specifically, we take views on companies not sectors, although we pay attention to prevailing headwinds and tailwinds. For instance, we see macroeconomic conditions as favourable for banks as the rate-hiking cycle lifts credit costs and boosts net interest margins.
That said, it depends on the bank; and financial firms in Australia and China are facing topdown pressure from regulatory investigations and tightening credit conditions, respectively. We like lenders in Singapore given their solid fundamentals and high quality, as well as the better-run, professionally managed private sector banks in India.
From a fixed income perspective, a differentiator for Asia is that numerous countries are on course for upward revisions to their sovereign credit ratings, including in the Philippines, Indonesia and India. Recent upgrades to Indonesia's ratings helped to speed up that market's inclusion in the global aggregate index this May, which should sustain foreign flows. Healthy fundamentals are helping to reduce volatility in the country's bond market, which we view favourably as we look ahead.
In India, fiscal conservatism and inflation targeting have lowered country and inflation risk premia. While we saw some fiscal slippage in the latest budget, the government remains committed to reducing its fiscal deficit. The rupee is also one of the least volatile currencies in the world, and the recent bond sell-off has improved valuations, which led us to increase our overweight to India.
We have also increased our overweight to Sri Lanka. Its bond market has a similarly low correlation to global risks. The Sri Lankan rupee is stable, the yield is high and the government is committed to structural reforms to reduce deficits.
Separately, Chinese bonds are starting to look interesting after the sell-off. Moreover, its debt markets have now met hard criteria for inclusion in global bond indices. We have shifted from underweight to a more neutral position in the local currency bond market, where we run hedges to alleviate intervention concerns.
Jeffrey: Earlier, I mentioned that the global economic growth outlook is positive - but it is equally important that increasingly in Asia we can find franchises which are driven by the attractive internal dynamics in the region and are not simply proxies for global economic activity.
For example, financials currently make up the largest part of the Asia Pacific Income portfolio. They offer an attractive risk/reward, underpinned by some high pay-out ratios and by the beneficial impact on earnings of rising interest rates. Also of course there are plays on the longerterm financial deepening which we expect to continue seeing in Asia.
The utilities sector is another area in which we're overweight given cheap valuations, attractive dividend yields, and the benefit to margins of any correction in the coal price. Conversely, while the technology sector contains some exciting headline stories, pay-out ratios tend to be low, or even zero, and so this is not a sector which we are generally able to exploit in an income portfolio.
Our country positioning is very much the result of our bottom-up stock selection: we feel we're better able to identify and exploit pricing inefficiencies and opportunities at the stock level than at the aggregate country level. That said, there are many interesting opportunities in Singapore and Thailand, while conversely there are few income opportunities within Indian equities.
Global investors remain under-invested in Asia and the emerging markets broadly. What factors might cause this to change, if at all?
Deepak: While Asian investors may have a natural affinity towards Asian markets, for global investors there are various considerations that they have to overcome. Asian markets are generally more volatile in comparison to the developed markets on account of the following risks: foreign exchange risks especially in the context of US policy tightening, policy divergence with respect to developed markets, growth and trade tariff concerns, not-normal distribution (fat tails), political, legal and corporate governance risks.
As a result, Asian markets have lagged the performance of the global markets until recently; EM equities delivered an annual return upwards of 37 per cent in 2017 showing investor confidence across emerging markets including Asia.
Investors do need to understand that the Asian markets form a key element of diversification in portfolio construction. There are many factors that are underway in the region which will continue to pave the way for investor confidence, namely, reforms as part of economic liberalisation, enhancement in exchange regulations, strong legal structure (eg bankruptcy laws), currency convertibility, easier access to market, and healthy corporate and sovereign debt management.
Irene: We expect the penny to drop sooner rather than later. We think the catalyst will be the inclusion of 222 A-shares into the MSCI Emerging Markets Index from this June, in tandem with the likely inclusion of Chinese central government bonds into global indices. Most international investors have not had to devote too much time to thinking about China's restricted equity and debt markets until now.
But index inclusion will force both active and passive players to switch focus. China's economy is huge, its markets are liquid and its sectors are varied. They simply can't keep ignoring it. We are witnessing a change in investor attitudes towards China and we expect them to start moving towards neutral or even overweight as its capital markets open up.
China's emergence will set 2018 apart as a pivotal year in the history of global capital markets. More generally, from a practical point of view, Asia simply offers better value. Its stock markets trade at a relative discount; its bond markets offer higher yields, a bigger cushion against rising US Treasury yields and better credit quality; and its currencies have been more stable. The region is better placed than developed market peers, with governments in Asia having deployed conventional, not distortionary, monetary policies.
Emerging Asia is forecast to account for half of the world's economic growth by the middle of this century. In contrast, advanced economies have raised their debt levels disproportionately, which will drag on future growth. If global investors have learned the lessons of the past decade, they will now understand the importance of diversifying across a broader range of markets less correlated to traditional advanced economies. They will come to realise that economic and interest-rate cycles less correlated to the US and other markets, and better risk-adjusted returns, make this region more attractive.
Jeffrey: Asia and Emerging Market corporates suffered from weak or negative earnings growth from 2011 to 2013, connected to the side-effects of a strong US dollar. Possibly for global investors this obscured the longer-term attractions of the Asian region, which are now asserting themselves more visibly once again as profits recover and earnings revisions sustain in a positive direction. We are glad to say that over the past months we have been seeing more flows into the region.
The longer-term story remains really good. Valuations are materially cheaper than those in much of the West, in particular the US. Investors might be surprised by the number of high-yielding stocks in Asia - that yield itself being an encouraging indicator of improving governance trends as company management teams pay more attention to the rights of minority shareholders. With decent dividend yield and earnings growing once again, we see opportunities for investors to make reasonable total returns from Asian equities.
What do you see as the biggest risks for Asia ex-Japan markets?
Deepak: An unexpected monetary-policy tightening due to inflationary pressures is a key risk to Asian markets. Apart from this, other risks for Asia include US protectionist policies; geopolitical events; commodity-price and/or currency volatility; faltering global growth; and renewed concerns about China's growth and financial stability.
Tighter monetary policy could likely bring attention to concerns around equity valuations, which are currently above long-term average levels supported by a benign interest rate environment. For equities, cyclicals and financials would likely fare best under this scenario, and as for fixed income, it's best to look at shorter duration portfolios.
In the event of trade protectionism, Asia markets with high foreign exports and therefore revenue exposure would be the most impacted.
Specifically for China, key risks to consider are: Risk of miscalculation of economic/market consequences of financial regulatory crackdown needs to be monitored. Deleveraging raises near-term liquidity concerns. Shadow banking risks linger. Tighter scrutiny of local government quasi-fiscal financing is a headwind for infrastructure investment.
The recent property upcycle is accompanied by rising consumer debt. Structural headwinds persist (eg high leverage and inefficient capital allocation). Other risks include renewed pressure on capital outflows; a setback in supply-side reform; and rising Sino-US tension.
For India, risks to consider: Elevated relative valuations remain a major concern. Faster pace of Fed/ECB policy normalisation and US protectionist policies are key external risks. Macro-stability concerns (eg the risk of fiscal slippage, higher inflation and a wider trade/current account deficit), a busy election calendar, and the likelihood of a meaningful rise in equity supply are headwinds.
Bank asset quality issues are not yet resolved and credit costs are high. A sustained rise in crude oil prices will have adverse macroeconomic implications. The long-term capital gains tax poses uncertainty.
Irene: Asia is sensitive to reckless fiscal policy under US President Donald Trump. By expanding the US budget deficit at a time of full employment through fresh tax cuts, the one guaranteed outcome is a blowout in the US trade and current account, which will spur Trump to enact more protectionist policies. With the US Federal Reserve projected to hike rates up to four times this year, Asia could come under some pressure as US and developed markets adjust, a scenario that could worsen if Trump's tax cuts lead to a major repatriation of US profits back home.
Market volatility is likely to increase if the pace of global economic growth is sustained and more central banks respond by tightening monetary policy. Volatility is a key concern for bond investors and net flows could turn negative sooner than expected. That said, the recovering growth environment that accompanies a rate-hiking cycle has tended to benefit Asian currencies. Asian markets also would experience related stresses in the event of sustained rallies in commodity prices, although that isn't our central expectation.
As for China, carrying out economic reforms should lay the foundation for more sustainable growth. Yes, deleveraging risks are markedly slowing China's pace of expansion, which may prove a challenge for the rest of the world. But data shows that even as activity in construction, infrastructure and housing has slowed in China, IT services have picked up. Growth in the services sector presents stock-pickers like us with opportunities. So while we expect China's growth to slow, there's no reason to think it will be abrupt. Trade tensions are rising as enthusiasm for globalisation gives way to protectionist impulses. In this respect how the US-China relationship evolves in 2018 will be key to regional and global growth.
Jeffrey: Tighter monetary policy of course is something that we continue to monitor, although the specifics of the pace and magnitude of tightening are very important to understand. Moderately higher rates on the back of stronger economic growth are by no means an unequivocally bad outcome - and indeed as noted above they are actually positive for areas such as the banking sector.
On balance, we think that China's reform programme is proceeding well, with an increased focus on more balanced and sustainable economic growth. Concerns about the amount of leverage in the financial system have certainly not vanished, but they have alleviated. Changes at the political level will not be uncontroversial for all commentators, but they do seem to be consistent with the setting of longer term objectives for the economy.
A risk which has been gaining in prominence recently is trade protectionism. It is too early to form strong views on how this will pan out. Part of a portfolio manager's job is to distinguish information from noise. We will continue to watch events over the coming months.