20 Oct 2020
China remains the largest and most important economy within Asia and this year sees the end of the 13th 5-year plan. Next year will see the start of the 14th 5-year plan and the leadership in China have been working on this and over the next few months some information will emerge, although a similar emphasis to the last Plan is expected. The last 2 or 3 Five Year Plans have had more focus on quality of growth than quantity of growth, demonstrated by the fact there has been less buoyancy in commodity markets since 2013. China is no longer growing exponentially and there is a greater focus on consumption than investment.
Consumption is important as US relations are difficult, and the government wants to preserve spending in the country. The authorities have a preference for people to spend money within China, as previously a lot of consumption leaked abroad due to outward Chinese tourism. Covid restrictions have meant that Hainan Island, a sub-tropical holiday resort, has become extremely popular and duty-free shopping there is booming. The ‘Made in China 2025’ goal will remain but may have a different title. China will continue to increase the value-added component of its manufacturing and encourage R&D within companies with a target of reducing import reliance. By way of example, China wants to achieve 75% chip self-sufficiency by 2025 from today’s level of only 25% as there is still a high dependence on imports from US companies such as Intel. Consumption in China continues to show a move from mass market to premiumisation and more up-market products. Whilst overall car sales are depressed, the high end, such as Mercedes and BMW, is doing well. Chinese companies with their own engineers are highly cost competitive as these are available at a third to one half of the cost of engineers in the US or Germany. China has moved away from being a cheap labour country. Companies with strong R&D such as Huawei, Alibaba and Tencent, together with certain pharmaceutical companies, are doing well. With most Five-Year Plans spending is front loaded as is often the case in the West when a new government comes to office.
The vision of President Xi is to take China to its rightful place in the world as a middle-income country respected by everyone. In China now there is something called the ‘Dual Circulation’ strategy to cut its dependence on overseas markets and technology and more about this will be revealed in the new Plan. China will not be reliant on exports to drive growth and wants to make itself strong to protect against the US and it has recognised that to achieve these aims there needs to be reform at the corporate level and not just reliance on inefficient SOEs.
Geopolitics remain difficult and Trump is not popular in China, whilst Biden is an unknown. Trump has weakened America’s role in the world by alienating allies, but is unpredictable, whilst Biden would get allies united, but is pro human rights which is an inconvenience. China believes that having an economy growing at 5-6% p.a. with a population of 1.3 billion, it will inevitably become a world superpower and can be patient in achieving this.
Stock markets look forwards and investors are now looking out to the end of 2021 to try and see how far the global economy will be below what had been forecast pre-Covid. China is a standout economy in terms of performance and has returned to 80-90% of normal levels of activity, excluding big scale sports events. Whatever the western media suggest, people in China believe coronavirus numbers are low, and have the confidence to live normal lives although continuing to wear masks. In the second quarter, almost every company recorded a significant recovery in their numbers. In China, economy wide industrial profits are up 20% year on year to end August. Construction and steel usage is strong.
North Asian economies have generally fared better than elsewhere, not just in Asia, but also globally, avoiding the so called second wave. China is a top down driven society and people tend to follow the rules. This is true across Asia where Confucian thinking prevails, and it is frowned upon to act in a way which is harmful not only to yourself but also to others. In China during the lockdown the army was there to enforce measures and many people live in relatively small districts called Wards where there may be 1,000 people who can be managed. These areas at times were individually locked down with food delivered to the gates. Heavy surveillance is a part of Chinese life – the game Mahjong is very popular in China and the military went round and took one piece from each game set of individual families, so groups of people couldn’t gather to play. The authorities in China have also used drones to monitor gatherings and disperse them if they occurred. In addition to this, Asia as a whole has lived through SARS in 2003, so knew how to react to quell the outbreak, something not present in the UK, Ireland, or the rest of Europe. People in Asia knew what to do when the pandemic hit.
For several North Asian countries outward tourism is much bigger than inward tourism, so travel restrictions have meant their domestic economies have seen higher levels of spending by staycationers. However, Thailand, and to a lesser degree Indonesia and the Philippines, have been hit in terms of some element of having tourist dependent economies. Thailand and Malaysia have handled the virus well, whilst the Philippines and Indonesia have seen serious problems and the small Philippine stock market which is never liquid has been hard hit. North Asia and Singapore have both had governments able to work out the right policies to deal with the virus and the internal infrastructure to implement this. In China, Taiwan and Korea, populations have trust in the government on managing the virus and the GDP shortfall for 2021 will be lower than elsewhere in the world.
India has always been a market with huge potential, provided they carry out reform. Early in the Modi administration bankruptcy reform and the introduction of the GST were positive, although the de-monetisation had little real economic impact. Reform stopped ahead of elections and Modi remains popular because he is decisive. Whilst the lockdown in theory was a good idea, the way it was implemented was very poor, but in recent weeks parliament has returned in India and some reform measures have been quickly passed. There is reason to believe that the reform process will now re-accelerate.
The non-bank Financial Crisis has taken time to fix, but now appears to be past the worst. Private sector banks in India continue to be well placed to gain market share and have successfully raised further capital above book value. Even the PSUs have seen strong deposit flows. Non-performing loans do remain an issue for these and some non-bank financials. Covid has hit the country hard but due to the young population mortality rates remain relatively low and the economy is now re-opening.
Emerging markets outside of Asia have been harder hit and this is where a large GDP shortfall, compared to what was forecast in 2021 is likely to occur. Latin America, South Africa and Russia have been hard hit by the virus, and while it has been better managed in Russia, this country has had to contend with the collapse in the oil price putting its budgetary position under severe pressure. In all these countries, lack of fiscal headroom has meant support measures for consumers have not been possible to implement, and as a result recessionary conditions are likely to prevail there for significantly longer than in Asia. Countries such as Mexico and Brazil have mishandled the coronavirus crisis and Mexico has recently announced economic forecasts derided as wildly optimistic. Consensus forecasts suggest a fall in 2020 GDP of close to 10% and a rebound next year of just under 3%. Mexico’s fiscal position is also closely tied to the oil price. In Brazil, the central bank has dramatically cut interest rates down to around the 2% level which has seen the Brazilian real weaken further, even during the risk-on rally which started in the second quarter. The economy in Brazil is forecast to contract this year by 5-6% and rebound next year by 3%. Investors will focus on whether Brazil sticks to its commitment to fiscal rectitude. Many Latin American countries along with South Africa are also dependent on commodity exports, many of which have seen price weakness.
All in all, within the emerging world Asia looks best placed, especially North Asia, for an economic rebound, and these economies will remain fast growing compared to both the emerging and developed world. Within Asia cultural factors mean that individuals have a strong desire to make more of themselves and there is still a generation of people who have moved from poverty to being better off and want to progress further. This will continue to be a driver of Asian economies. With supportive valuations and the likelihood of further significant US$ strength diminished; Asia looks well placed to outperform over the remainder of the year.
In the most immediate short term, President Trump succumbing to the coronavirus has created a further level of uncertainty, but at the time of writing it would appear that the President has recovered and the election date will not be delayed. The US election itself could well result in stock market volatility and uncertainty, especially as the incumbent has stated he may not accept the result if the polls suggest he has been defeated. If Biden is elected, this is likely to be a positive for growth in the short term due to his fiscal policies, and unless the Democrats achieve control of both Houses of Congress, tax increases on the wealthy in any significant manner are unlikely in the short term. Even if these did occur, wealthy people tend to save, whilst giving more money to poorer people is money that is spent now. Europe is also spending more. The biggest GDP gap in terms of a shortfall from where it would have been in 2022 will be in Latin America, South Africa, and Russia. Even within Asia there is a divide between North Asia and some of the Asean countries (excluding Singapore) and India is also struggling, although now seemingly seeing a rebound in economic activity from its lowest levels. China and North Asian countries will not be far off what GDP would have been anyway.
The pandemic has demonstrated the importance for investors to think in terms of sectors and themes which arguably have been a greater driver of returns than country selection. Even in the best performing major market, the United States, there has been a huge divergence between the S&P 500, especially the internet related names, and the median US listed company. This pattern has been seen across the globe with the market leaders in every country being ‘new economy’ related names. Within the service sector companies not reliant on high levels of personal service have fared best, whilst those dependent on high levels of human interaction have seen significant declines in demand for their product, often with a highly damaging impact on their balance sheets, which have resulted in the permanent destruction of value for equity holders. Fund managers who were slow to react to this are those propping up the performance tables, in many cases showing significant losses.
The Tencent company motto is that technology is always changing, and Tencent is always changing, and corporates slow to do this have suffered. There is no sign of a reversal to the accelerated level of structural change in the post-pandemic world, and many spending patterns, even with a vaccine, may well have been permanently altered. Asian economies without a history of legacy businesses, traditions, or brands, seem well placed to capitalise on the opportunities presented in a fast-changing world. Global technology and consumer internet stocks look likely to continue to benefit from network effects in which the strong get stronger. ESG factors are also likely to be an important consideration by investors. Increased fund flows into ESG conscious managers is shifting equity flows towards certain sectors, and managers who have shown an unawareness of the importance of ESG have struggled in recent years.
To date de-globalisation has not been a significant negative for Asia in general, or China. Many Chinese companies with the help of government support are likely to emerge in the long-term stronger from the short-term difficulties US tariffs have presented. China is now around 20% of global GDP on a PPP basis. Chinese companies have also moved manufacturing operations to other places in Asia including Vietnam. Even the green agenda in Europe is likely to benefit China as it is the world leader in the production of solar panels, wind turbines, and Asia is very strong in the production of EV batteries and charging stations.
In the short term, news flow will drive market direction and volatility, continuing to take into account new cases of the coronavirus, vaccines/treatments, and economic data such as PMIs. Investors should remember that technical factors such as whether markets are overbought or oversold will also at times amplify initial moves driven by fundamental news flow.
Looking beyond the next six months, there is a strong probability that a combination of a widely effective vaccine and better treatments will see an acceleration in the level of economic recovery in the second half of next year. When this does occur, this is likely to be a catalyst for a rally in hard hit value sectors of the market, although how long-lasting this will prove is a moot point. For 2021 and much of 2022 monetary policy and liquidity are likely to remain positive for financial assets. Already this year the pattern of markets front-running economic recovery when liquidity conditions are benign has been demonstrated. The second half of 2021 is when the global economy is likely to return to trend growth, but there remains huge stimulus in the financial system with few governments likely to significantly tighten fiscal policy until 2022 at the earliest. Central bank QE policies have tightened credit spreads, and this too remains a positive for equity markets.
Beyond the medium-term horizon, market concern may focus on the possibility of higher levels of interest rates and the cost of paying back government debt, together with the withdrawal of QE, but this is unlikely to be an immediate concern to investors. Investors themselves appear to have taken a longer-term outlook on businesses with their being less interest in companies which are ‘cheap’ on a short-term basis if the market believes that on a five-year view profitability is going nowhere. This helps explain the continued outperformance of new economy type businesses and the reluctance of investors to support companies in structurally challenged sectors. Banks, for example, still face uncertainty over asset quality and deterioration from their commercial loan books, and legacy parts of their business face the persistent challenge from digitalisation.
In previous outlooks we have constantly stressed to investors the importance at times of uncertainty and market noise to focus on three drivers of equity markets. The first of these is economic and market fundamentals, and the post Covid world has already demonstrated a huge divergence between winners and losers at the corporate level. This has also been seen at the country level and FT writer Gillian Tett has commented that with Covid ‘we are in the same storm but not the same boat. Those with capital have generally done well through the pandemic, whilst those without are suffering’.
In the developed world this has been seen in the discrepancy in job losses between those that are able to work from home and those that are not, and the financial suffering of the large number of people working in the informal economy in third world countries. Whilst it is obviously a generalisation, consumers in the West have been better placed in terms of owning capital than those in the emerging world, especially Latin America, Southern Asia, and Russia. Those that hold assets such as equities or housing have seen the value of these increase, because of central banks super-loose monetary policies. In contrast, people without assets have seen their net wealth shrivel with the recession hitting wages and employment. Overall, economic fundamentals have not proved to be as dire as was initially feared at the onset of the pandemic and fundamentals look likely to improve over the next couple of years due to supportive central bank and government policies and a significant lessening of the impact of the virus, especially on mortality.
The main negative for markets remains valuations, which in the developed world on short term numbers are ahead of medium- or longer-term averages. Valuation indicators such as PE ratios (yield is too uncertain to analyse) remain high at an absolute level, however, this needs to be weighed against the earnings yield available from equities versus other assets. The re-rating of equities is explained by the lower discount rate and a realisation that cash rates will remain at rock bottom or negative levels for many years to come. Even for the highly rated glamour tech sector, the earnings yield remains above short-term interest rates. Whilst global liquidity remains plentiful, this is likely to remain a positive for equity markets.
Government bonds continue to look expensive, but current levels of yield will be supported by low short term rates for many years to come, central bank actions preventing a significant rise in longer term bond yields, and continued liability matching by institutions in certain countries. Actions by central banks, including the buying of selective high yield credit, has significantly reduced the default risk within corporate debt and with re-financing readily available, defaults outside of the US shale sector have remained low. A further tightening of credit spreads seems more likely than a significant widening and this remains supportive of equities globally.
Technical factors in the US in September showed the market to be overbought and since then there has been a small pull back. The reported influx of private client investors in some countries may be a realisation that real cash rates will remain negative for many years to come. Some markets such as China and India will benefit from the increased penetration of institutional pension and savings products which should generate domestic inflows into their markets. Fund manager surveys suggest institutional investors still hold significant levels of cash.
As we enter the fourth quarter it should be remembered that the early months of this period have often seen higher levels of market volatility and, with the likelihood of a slowdown in economic recovery, together with the US election and Brexit negotiations, this seems likely to be the case once again. The fourth quarter of the year is generally a strong one for investors and with the likelihood of positive announcements on coronavirus vaccines and treatment, investors should continue to focus on the prospects of continued economic recovery in 2021 in an environment where low rates and plentiful global liquidity should continue to support financial assets.
Graham O'Neill, Senior Investment Consultant, RSMR
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