Time for a closer look at investing in Asia
Pessimism towards emerging markets in Asia appears excessive
After years of tracking closely with their emerging markets peers, Asian equities have more recently moved ahead, so it’s worth examining what’s behind this decoupling.
During the 10-year period between 1998 and 2007, performance of the MSCI Emerging Market (EM) and MSCI AC Asia ex-Japan index were very similar; they basically moved in lockstep with each other.
In the wake of the Global Financial Crisis (GFC) in 2008, the correlation between the two benchmarks remained high. However, starting in 2012 we began to see a breakdown in the strong correlation trend.
And the reason for the decoupling of performance between the two benchmarks? It’s worth recalling that China’s demand for commodities to develop its vast infrastructure network really took off in the early 2000s. Fixed asset investment carried on even after the GFC, as Beijing continued to dish out large stimulus programmes to avert an economic hard landing.
In 2012, however, China began to ratchet back credit growth, which marked the beginning of the end of the commodities “super cycle”. As a number of the non-Asian Emerging Market index constituents are commodity-linked economies, it would explain the correlation between their economic performance during the period when China was investing massively in infrastructure, and the resultant weakness in their economies since 2012, when the rate of China’s fixed-asset investment started slowing.
Geopolitical problems in recent years have further compounded the current risk aversion in a number of non-Asian EM countries. And with the possibility of a US Federal Reserve rates lift-off looming, one can perhaps understand the exodus by investors out of emerging market equities.
As Asia falls within the emerging markets classification, it is understandable why some investors may have tarred the region with a similar brush. However, our view is that Asia could be the bright spot and offer investors a good risk-reward shelter for emerging market exposure.
There is no denying Asian economies are confronted with numerous challenges today, including adjustment to the ‘new normal’ global growth rate and the impending normalisation of US federal funds. In the short term, with a number of Asian economies undergoing rebalancing, we expect growth indicators to remain volatile. However, despite a projected slower growth pace than over the past decade, the Asia region is forecast to lead world growth over the next few years according to market consensusgrowth forecasts.
A number of Asian governments are determined to push through reforms designed to remove the obstacles that are capping their economies’ growth potential. For example, China has implemented numerous policies to restructure inefficient state-owned enterprises, promote new industries and further liberalise its financial system. Japan has implemented new laws to promote better corporate governance and capital management. India is progressing with labour law reforms to make the country more business-friendly. And South Korea has changed its tax system to encourage companies towards better capital management practises.
Fiscal reform related to infrastructure investment will also be a key driver of growth for Asia, in our view. In particular, India and Indonesia’s growth potential has been hampered by their lack of domestic infrastructure. Indonesia’s president, Joko Widodo, recognises this challenge and has outlined ambitious plans to upgrade the country’s land and sea routes. China’s “One Belt One Road” initiative, with a large funding commitment from Beijing, should help promote exports as well as closer collaboration with its trading partners.
As a net importer of commodities and energy products, Asia benefits significantly from the recent weakness in commodity prices. Given the structural demand-supply forces in the global commodity market coupled with the ‘new normal’ softer global growth trend, we expect commodity prices to remain suppressed for some time. Weak commodity prices have meant, for example, lower input costs for Asian businesses, which helps to boost their margins.
The steep decline in commodity prices has been a powerful disinflationary force globally, and in Asia, low inflation has paved the way for economies such as those of Indonesia, India and China to push through price reforms for energy and utilities. As a result of recent energy price reforms in India and Indonesia, both economies are now benefiting from a much-improved fiscal position, making them less vulnerable to a future US rate-normalising cycle.
Furthermore, low inflation has enabled many Asian central banks to trim benchmark rates to support growth. In fact, with inflation easing significantly across the region, many Asian economies are now on an easing bias.
Equity valuations in Asia are attractive, with the MSCI Asia ex-Japan index trading below its five-year average price-to-earnings multiple of 10.7, based on FY 2016 consensus estimates as of 30 September 2015. This is well below the P/E average of the US and European markets. Furthermore, the 12-month trailing dividend yield for the region is averaging nearly 3 per cent.
And while concerns over the slowing pace of growth in China is warranted, at a forward P/E of 8.6 consensus estimates, we would argue that the risk-reward for Chinese equities have become even more appealing. Especially when the property sector in China is showing encouraging signs of a recovery, with both sales volume and property prices rebounding since the second quarter. Recall that the real estate segment directly contributes to nearly 25 per cent of China’s overall economic activity, and stabilisation in this area is a significant development, and minimises a hard-landing scenario, in our view.
The current market sentiment towardsAsia is approaching levels not seen since the summer of 2013 when expectations of a Fed lift-off sparked a bout of risk aversion. We believe a number of economies which came under pressure then -- most notably Indonesia and India -- have healthier balance sheets and more fiscally-prudent governments in place now. Furthermore, Asia, apart from Indonesia, has a benign inflation backdrop, providing room to absorb any inflationary impact from weaker currencies. And with commodity prices likely to stay depressed, there is little pressure for central banks to tighten monetary policy any time soon.
While we don’t exclude volatility in both the equity and currency markets remaining high, we think conditions will improve after the first US rate hike. .
Arthur Kwong is Head of Asia Pacific Equities at BNP Paribas Investment Partners