Forget reflation, it's 'Goldilocks'

HALFWAY through 2017, equities in Emerging Markets (EM) Asia have rallied over 15 per cent, with four in five companies in the MSCI Asia ex-Japan Index in positive territory. Yet, economic growth is slowing globally and commodity prices have fallen. Market fears have moved from one political event to another and now seem to revolve around whether the "reflation trade" is over.

While we also expect a period of higher volatility ahead, we believe that the market is asking the wrong question. In fact, to the extent that "reflation trades" overlapped with "Trump trades" late last year when US-led stimulus expectations sent US rates and the US dollar (USD) surging, they were negative for EM Asia.

We believe that the current combination of mild growth and inflation, with moderate policy and low interest rates, provides powerful support for asset valuations. In addition, we see three key supporting factors for EM Asian equities, including a potentially weaker USD, reform benefits in China and India, and still under-positioned global investors.

A topping USD

First, we believe that the slowdown in US growth is temporary and is likely to rebound in H2. Still, this growth trajectory is much more benign than the one the market expected at the start of the year, when expectations for fiscal stimulus and trade protectionism were very strong. Fed policy normalisation will continue, but is likely to be gradual and the upside risks for long-term rates are limited.

This means that US economic and policy outlooks are no longer much stronger than the rest of the world. As a result, the USD is likely to peak in the coming year after a six-year rally. There may still be some short-term upside risks to the USD if US tax cuts take place, but that is likely a one-time event ahead of a longer trend of a weaker USD.

This makes EM outperformance likely. Since the USD rally began in 2011, EM Asian equities have underperformed the US by a large 42 per cent (Figure 1). This is because investors increasingly preferred USD assets, particularly after oil prices collapsed and China's renminbi (RMB) depreciated.

Now, with oil prices subdued, RMB imbalances squeezed out and the USD at its peak, EM Asian equities may reclaim some lost ground. Previously, foreign exchange (FX) risk was a major headwind against investor flows to EM, but FX may be a tailwind in future, as potential currency appreciation can draw investors.

Within EM, we see broad opportunities. Latin America is probably the most under-priced. But Asia is where sustainable growth is still the strongest. External funding needs are limited, with mostly current account surpluses and ample FX reserve coverage of short-term external debt.

Reform beneficiaries

We see opportunities across the region, but believe those that are going through monumental reforms, such as China and India, will offer the best potential returns.

China remains on top of the list of worries. Many cite the fall in iron ore prices as a sign of the worst to come.

However, steel prices in China have remained elevated, which is a direct result of supply side reforms that have dramatically cut down capacity for industries such as steel, returning the industry to profitability.

Moreover, China's corporate sector is deleveraging under regulatory and political pressure. This has brought much shadow financing back into the traditional channels, which is likely to lift banks' asset quality in the process. Higher interest rates and falling inflation suggest a more dovish tilt for monetary policy in the second half. A more flexible exchange rate regime also helps to adjust domestic imbalances.

China's debt risks are contained. The deleveraging in the corporate sector is offset by more borrowing from government and households who have very low leverage by global standards. Observers should also look at the high growth in savings and wealth, rather than just debt. The financial system is healthy enough to support economic growth, particularly in the sectors that are still offering sustainable high growth.

The MSCI finally recognised this progress and added China A-shares to its benchmark. The initial 0.7 per cent weight in the EM index (0.08 per cent of the global index) is irrelevant to flows. But as the A-share market is worth about US$8 trillion, or 11 per cent of global equity market cap, we would expect rapid additions to this weighting in the coming years. At around 13x forward earnings, valuations are not demanding.

In India, CPI (consumer price index) inflation has fallen to 2.2 per cent, the lowest in more than 15 years. Yet, the policy rate and short-term government bond yields (local risk-free rate) remain far higher at above 6 per cent. The Reserve Bank of India is so far holding back due to concern that the Goods & Services Tax (GST) to be implemented in July might lift inflation. But we believe this is only a small hurdle and expect at least one rate cut in H2.

This would support the nascent rebound in credit growth, which would be conducive to fixed investment that is needed to unlock potential for urbanisation and productivity growth. The GST aims to unify the nation's irregular local tax system. It may weigh on Q3 growth, but is likely to enable greater interstate commerce in the longer run. Although Indian equities are a global consensus overweight and are not cheap at 19.4x consensus 2017 earnings, they are also more likely to deliver on growth expectations of 15 per cent on average for 2017-18.

Global investors

Perhaps the strongest argument for EM Asia is that most global investors have underweight positions. EM Asia is the largest underweight among EM regions for global fund managers. South Korea, China and Taiwan are the three biggest underweights.

Fund inflows to the region picked up in June, with the largest inflow since mid-2015. The three biggest underweights received relatively large inflows through mutual funds and ETFs (exchange traded funds) in June. We believe this is just the beginning of a trend, as global investors begin to appreciate the implications of a weaker USD and the structural improvements taking place in this region.

As strong as the case is for Asian equities, one should still be selective and disciplined. We see secular consumption growth as the major trend to build portfolios around. This trend is present in many industries, including cars, healthcare, e-commerce, leisure, insurance, education and environmental preservation.

Best-in-class companies with sustainable growth prospects that could generate compound earnings growth of 15 to 25 per cent per year are preferable. Also, stay invested. While it is important to monitor cyclical and policy developments, there is often too much noise in the markets. Hence, unless there are major trend-breaking developments, investors should not be trying to pick small peaks and bottoms, but rather allow the trend to accumulate returns. W

Ken Peng is Investment Strategist, Asia-Pacific, Citi Private Bank