08 Aug 2018
Asia faces near-term challenges, but is well positioned given solid fundamentals.
Asian equity markets’ stellar performance last year was largely driven by positive earnings surprises, a phenomenon we are less likely to see repeated in 2018. There are signs that consensus earnings forecasts may be slightly too optimistic in some areas, but we also expect to see a fundamental softening of growth for Asia, and a weaker revenue growth environment for the companies that operate there.
There are two main reasons for this. Leading economic indicators of global growth are starting to roll over; suggesting exports growth is likely to slow – a key driver of better earnings growth last year. Secondly, China’s economy is starting to slow as a result of current policy settings. Initiatives to tackle excessive credit growth, reduce financial risk and improve environmental protection are all long-term positives in our view, as they address some of the markets biggest concerns, but in the near-term they are likely to see a weakening of economic growth in China.
A key source of uncertainty in the outlook for global growth has been the escalating trade tensions between the US and its major trading partners. This has raised concerns over manufacturers’ costs and global supply chain disruption, as well as the potential impact on global economic growth. Negotiations between the US and China have been tough, with President Trump happy to ratchet up the pressure by announcing further rounds of potential tariffs.
It is very difficult to predict how events will unfold, but it is encouraging that so far the response of others has been unequivocal but proportionate. While the danger is that tensions escalate further, the hope must be that we are in a process of negotiation and that the US President can obtain enough concessions to support his approval ratings ahead of mid-term elections. Longer term we would expect relations between the US and China to remain tense but less hostile as the implications become clearer.
China is in a constant balancing act between reforming its economy and maintaining a reasonable level of growth. The authorities have recently had a single-minded focus on reducing financial risk, but the threat of a trade war has raised expectations that it will shift policy towards stimulus as it seeks to protect the downside risk to its economy. So far we have seen cuts in the banks’ reserve requirements to ensure there is enough liquidity in the system, with a cut in personal income tax for the middle class to try and boost disposable incomes, and by extension the domestic economy. While the government is unlikely to reverse its deleveraging drive, the balance between avoiding a sharp slowdown in growth and avoiding excessive stimulus is becoming more delicate.
Another major concern for investors is the risks that come with a faster pace of monetary policy normalisation in the US. Asian currencies have been relatively resilient against a rising US dollar, with the exception of the Philippine peso due to its current account deficit and signs of inflationary pressures. Elsewhere, Asian current account balances have generally improved in recent years and inflation remains contained. We believe that a lack of overheating pressure from China can help keep a lid on inflationary pressures in the region, suggesting only moderate interest rate rises.
Asian equity markets appear to have stabilised after a weak second quarter and valuations are starting to look more reasonable again, compared to long-run historic averages. In terms of price-to-earnings, Asia also continues to trade at an attractive 25% discount compared to the MSCI World index. However, in the near-term, a re-rating appears less likely given earnings are no longer surprising positively, trade tensions have been escalating and further US interest rates hikes are expected.
While valuations and positive surprises in earnings are less likely to drive equity returns in the near-term, there is quite a good dividend growth story in Asia. As can be seen in the chart below, this can be traced back to the aftermath of the global financial crisis, since then the region’s capex/sales ratio has been steadily declining. While this does in part reflect lower structural growth in the region, it also demonstrates that Asian companies are more cautious, focused and better managed than they were historically. This means that better returns on capital are more sustainable. The flipside of Asian companies being less capital intensive is that they have been generating stronger free cash flow. The challenge has been how to better allocate that capital, with management facing growing pressure from minority shareholders to pay better dividends.
Fig.1 Corporate capex discipline should support returns
Source: Worldscope, FactSet, Citi Research as at 9 May 2018.
Over the medium-term, our outlook for Asia is cautiously optimistic. The region’s economic and corporate fundamentals remain solid, and it remains the biggest driver of global growth. In particular, we are encouraged by the capital discipline being displayed by Asian companies. This is being reflected at the macro level too, with limited credit growth in a number of countries. Together that should support profitability, which in turn should support the equity market.
Ian Hargreaves is Asian Equities Fund Manager for Invesco Perpetual.
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