Outlook for Asia turns brighter: (1) Economic resilience in the face of external pressures

It's no secret that the external environment has been and continues to be particularly challenging for the Asian region. These challenges came in the form of the slowdown in China, the continued strengthening of the greenback, rising U.S. interest rates, sluggish global trade growth and the rise of trade scepticism led mostly by the current U.S. Commander-in-Chief.

Yes, on the macro level, it has not been an easy two to three years for the Asian region, which makes it all the more surprising that Asia has remained relatively resilient in the face of these external pressures. As can be gleaned from Chart 1, the major ASEAN economies have continued to grow around 5 per cent, the average since 1990, despite these pressures.

(2) Reforms to resilience

Much of this resilience could be explained by the internally driven economic reforms undertaken by many of these economies triggered in part by changes to key leadership positions. From Modi to Jokowi, and to some degree, Duterte, Asian economies have gained from a more reformist economic agenda.

The impact of such reforms is often hard to quantify, in part because it can be difficult to distinguish promises from execution. But the World Bank's "Doing Business" rankings, which measure a range of indicators that affect the ease of doing business, offer some objective view on the subject, and the results for Asia seem promising.

As can be seen in Table 1, large developing economies in Asia especially Indonesia, the Philippines and Vietnam have generally seen much better improvement in rankings in recent years thanks to the impact of economic reforms. The World Economic Forum and Transparency International compile similar measures and they show the same trend.

An improving business environment helps to explain the increasing attractiveness of the ASEAN region for both foreign direct investment (FDI) and domestic investment flows. A decade ago China dominated FDI inflows into Asia, but now these are matched by flows into the ASEAN region.

FDI inflow is positive for economic growth as it brings with it long-term capital, as well as technology, managerial expertise and links to the global economy. After nearly two decades of a shortage of capital - after the Asian financial crisis - there are strong returns on higher investment levels.

(3) Rising tide lifts all boats, Asia included

Aside from the impact of economic reforms and better policy management, the confluence of other external factors including weaker exchange rates, higher commodity prices and brighter growth prospects in the developed world have also improved the growth outlook of the Asian region.

Indeed, across major economies around the world, sentiments of manufacturers have improved consistently over the past few months, an uptrend that appears evident even before President Trump's victory in November, as evidenced by the manufacturing Purchasing Managers' Index (PMI) figures in Chart 2. Anything above the 50-point line is a sign of expansion, so collectively the PMI figures send a positive message about growth prospects in the developed markets and China. 

Improving external conditions have stoked business sentiments in Asia as well, where manufacturing accounts for a high proportion of their domestic economy. This is evident in Chart 3 where the latest manufacturing PMI readings in most Asian countries have materially improved from the low point in 2015.

(4) Global trade cycle showing tentative signs of improvement

In addition, there are tentative signs that the global trade cycle is improving. Global export growth is recovering from double-digit year-on-year declines in 2H2015. In level terms, export values show early signs of strengthening as commodity prices have stabilized. The Baltic Dry Index - an alternative indicator for world trade - has also picked up over recent months as shown in Chart 4.

Across Asia, the relative uplift in global spirits has translated into better export prints for pretty much every major economy in the region. Indeed, looking at the latest three available exports data, the outturn has been besting market expectations.

A recovering global trade environment could be a positive signal for Asia ex-Japan equities as these regional stocks tend to be a play on global export strength in part due to its heavy weighting of non-resource cyclical sectors and Asia’s role in the global supply chain.

But risks remain: (1) Federal Reserve - Ready to hike

Yet, a relatively more hawkish Fed could potentially rain on Asia's parade should the U.S. central bank be able to deliver a quicker pace of rate hikes this year.

Improving inflation prospects, tight labour markets and record high stock markets weaken the argument for further prolonging monetary accommodation. Recent Fed speak also suggests a consensus building towards hiking interest rates with higher frequency this year. In addition, the Fed seems comfortable enough with the trajectory of rate hikes to be willing to table discussions on decreasing the size of its massive balance sheet in subsequent meetings. They look set to deliver three rate hikes as promised.

Ultimately, we cannot ignore the fact that the prospect of higher interest rates in the U.S. could lead funds out of emerging markets into higher yielding currencies such as the U.S. Dollar. 

Fortunately, Asia seems relatively resilient to these pressures on account of its healthy current account surpluses, flexible exchange rates and considerable foreign exchange reserves (Chart 6). Also, countries like India and Indonesia have narrowed their current account deficits quite substantially over the past few years. These factors ensure that Asia remains in a relatively sound position to deal with further tightening in U.S. monetary policy and potential volatility in currency markets. 

(2) Protectionism: Action and Retaliation

A key uncertainty that continues to hang over the Asian region is President Trump's penchant for protectionism. Mr Trump's "America First" policy agenda is particularly disconcerting for a region that has greatly benefitted from globalisation in recent decades. Participation in global production networks has been and continues to be an important part of the rapid development of the Asian region.

Mr Trump seems determined to take to task countries which the U.S. has substantial trade deficits with. China appears at the very top of that list, followed by Japan and Germany. With China accounting for more than 40 per cent of U.S. trade deficit, it is little wonder that the country has been the key focus of Trump’s anti- trade rhetoric.

Given the interconnectedness of global production networks, punitive trade policies that target China would inevitably threaten the rest of the Asian region indirectly as much of its trade with China is dependent on demand from the United States.

With this in mind, within the Asian region, major economies like Malaysia, Korea, Thailand and Singapore seem most susceptible to U.S. trade protectionism pressures considering that these countries have a more substantial trading relationship to both the U.S. and China as can be inferred from their exports to these countries as a percentage of GDP in Chart 8 below. More domestically driven economies like India and Indonesia, and to some degree, the Philippines, would be less vulnerable to such trade pressures. 

Also, one should not expect China to remain quiet on these threats. Should Trump implement his punitive trade measures, retaliation from China is to be expected. An all-out trade war will be disastrous for all involved.

So far, and quite surprisingly, the Trump administration has stayed relatively quiet on trade relations with Asia. Yet, this may well be the calm before the storm as appointees to top trade-related positions in the Trump administration reinforce the view that, at some point, relations with China will become more confrontational. If the Trump administration continues to handle trade issues with some degree of predictability combined with a lot more jawboning and less tangible policy-making, then prospects for Southeast Asia could remain bright. The reverse is also true.

(3) China: Renewed downturn potential headwind

A third risk is China, but this is less of a concern than it once was in 2015. China continues on its bumpy journey towards rebalancing its economy. The long and at times painful process has sparked periodic investor panic, and this is unlikely to end anytime soon. Nevertheless, there are certain macro developments in China that could be positive for risk sentiments.

First, China has managed its currency depreciation rather smoothly, without sparking any of the usual market panic or stress. The weaker Yuan is easing deflationary pressures in China's battered industrial sector as can be gleaned from Chart 9. Second, higher producer prices could improve Chinese corporates' pricing power and profit margins, which may improve earnings in the more cyclical and industrial parts of the economy. This should provide some near-term support moving forward.

Such support is certainly welcome considering that the People's Bank of China (PBOC) has implemented tougher macro-prudential policies and tightened liquidity conditions amid rising concerns over the overheating housing market. This potentially points to slower growth in coming months. Higher consumer prices could also diminish the appetite for further monetary easing; removing what was once a key support for the slowing economy.

Another key source of worry is China's inflating debt bubble. Of late, Chinese policy-makers seem determined to deliver solid growth over addressing the potential long-term problems from the credit bubble. As a consequence, the debt service burden is rising (Chart 10), bringing the risk of an increase in non-performing loans. Notably, most of the debts are in local currency so the government should be able to prevent abrupt systemic disruption. Nevertheless, it is a longer term issue investors should be cognizant of when investing in Asia.

A good time to invest in Asia? - Wider range of returns amid downside risks and relatively rich valuations

So, amid both the positive and negative signals coming out of Asia, the question beckons: Is it a good time to invest in the region?

For a number of years now, investing in Asia has largely been a valuations story – Asian stocks were a compelling investment because stocks were trading at cheap valuations versus developed markets and its own long-term history. Indeed, at one point, Asian stocks were trading more than one standard deviation below its 10-year price-to-earnings multiple and 10-year average trailing price-to-book. The risk-reward at these valuations seemed attractive.

However, at this juncture, while Asia is still trading at a substantial discount to its developed market counterparts (Chart 11), valuations are now closer to its longer term average (Chart 12). Essentially, it's no longer cheap against its history. Hence, the argument for cheap valuations need not be as compelling as it once was, even while it remains valid on a relative basis.

Also, rising protectionism pressures, faster-than-expected U.S. interest rate normalisation and China's bumpy rebalancing may increase the downside risks of Asian stocks. On balance, we expect a wider dispersion of returns, with the upside likely limited by current valuations.

Indeed, amid potentially choppy terrain ahead, we would advise against taking very aggressive broad directional bets on regional equities. As such, we continue to maintain our cautious view on Asian stocks until such time we have clarity on key uncertainties hanging over the outlook of Asian markets including President Trump's trade policies and the magnitude of China's slowdown. 

Cautious does not mean bearish

That said, cautious does not mean bearish. If anything, on a macro level, things are certainly looking up for the region. There will always be risks, but that should not mean avoiding a region altogether.

To put things in perspective, consider the returns on Asian stocks versus developed markets over the past 5 years (Chart 13). Asian stocks have largely underperformed developed markets on a total return basis, having priced-in much of the bad news in 2015 during the height of the commodity slump and market ructions resulting from concerns over China's growth and abrupt changes in economic policy.

Yet, with developed market stocks running up as steeply as it has, Asia's underperformance and significant valuation discount could enhance its relative investment appeal. Should Trump forego his protectionist ambitions and should China continue to extend its current economic stability and avoid a hard landing, fortunes in Asia may turn and regional stocks could play catch-up with its developed market peers. Thus, exposure to this potential longer term story could be beneficial.

So yes, while we should avoid broad directional regional bets, there is still scope to take exposure to pockets of opportunities available in the region in the context of a long-term investment horizon.

Favour a selective and nuanced investment approach against a directional regional bet

In this case, one should give due consideration to the type of investment strategy deployed for example, favouring strategies that can limit the downside while investing in the longer-term potential of the region.

The latter means taking selective exposure to stocks which can benefit from the long-term structural story in the Asian region. Take China as an example. Underneath China’s economic transition is the divergent force of a "New" China breaking away from the shackles of the past. "New China", led by innovative companies and their emphasis on middle class consumption, is pulling ahead and making great strides, while the "Old China" is burdened by bloated state-owned and heavy industries. Hence, exposure to "New China" stocks is a way to ride out that long-term growth story.

In ASEAN, many economies such as Indonesia, the Philippines, Vietnam and even Malaysia are undertaking massive infrastructure development projects as they invest to build up the capabilities of their own burgeoning economies. Indeed, there is reason to remain optimistic on the multi-year outlook for ASEAN infrastructure spending as the need for further infrastructure build-out seems particularly acute. ASEAN’s infrastructure investment needs are estimated at US$110b or more annually till 2025 according to the 2015 ASEAN Investment Report. Also, the potential to stimulate broader economic growth and reinforce voters’ support gives political leaders the impetus and incentive to sustain infrastructure spending even in difficult times. Again, these are longer term narratives that provide opportunities for investments in the region.  

The rise of middle-income consumption in Asia is yet another longer-term theme that could be attractive as prosperity in Asia rises. Stocks that offer exposure to the region’s domestic demand growth could be a viable way of playing on such themes.

Beyond these thematic investments, there are also ample opportunities for income investing in Asia. As can be gleaned from Chart 14, Asia Pacific stocks tend to offer higher dividend yield relative to their developed market counterparts. In addition, taking reference from the MSCI Asia Pacific Ex-Japan index, sectors like financials, real estate and telecom have historically offered close to 4 per cent dividend yield.

Essentially, investing in the long-term potential of Asia requires a nuanced, bottom-up stock picking investment strategy to build a portfolio of sound Asian companies.

Mitigate downside risks

On the other end of the spectrum, as we take exposure to a variety of quality stocks in Asia, mitigating the downside risks is important as well. The time-tested approach to do this is via diversification through a multi-asset strategy. This means taking judicious exposure to a variety of asset classes including stocks, bonds and other alternative investments. Typically, less volatile asset classes like bonds could function as risk mitigation tools for a portfolio. At the same time, Asian bonds can offer attractive yields relative to developed markets like the U.S., Europe and Japan.

Options and other derivatives, when used judiciously, can also provide much needed asset diversification.

Active management remains crucial in view of risks ahead

In view of wider return dispersions and potential macro and idiosyncratic (i.e. demonetisation policy in India) risks ahead, an investor may not be rewarded through passive management alone.

A potentially choppy investment terrain ahead would require a deft investment hand at the helm to rebalance the portfolio when necessary or take exposure to certain assets as and when opportunities arise.

An actively managed unit trust solution could meet the needs of a bottom-up stock and bond selection strategy, asset diversification as well as active management. Investors should consider a unit trust as a means of attaining some peace of mind when investing the long-term potential of this ever changing and ever interesting region.

So, does Asia deserve a second look? It depends largely on the lens through which you look. With a thoughtful investment strategy in place, the answer would probably be "yes".