Economics

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Asia Ex-Japan

Outlook

Special focus on Asia ex-Japan

First in, first out

14 July 2020

The virus

Asia ex-Japan – specifically the ASEAN 5 plus China, Hong Kong, Taiwan and South Korea - stands apart from its Western peers. Having lived through the SARS epidemic of 2003, the region seemed better prepared in tackling the public health challenges of Covid-19 versus its Western peers. There was little public resistance against important mitigation steps including physical distancing, travel restrictions and mask wearing.

Institutional memory from fighting the SARS virus in the early 2000s was particularly useful in ensuring a quick and vigilant response to the pandemic. The result is a region that did not observe cases frothing over the brim. Of course challenges remain, with India, Indonesia and the Philippines among those still struggling to contain the spread of Covid-19. But, as things stand, we acknowledge that Asia ex-Japan seemed to have handled the crisis better than their Western peers.

In particular, China’s battle with the virus underscore the sheer importance of moving quickly and decisively. The country was quick to respond to the public health crisis with draconian measures including issuing strict travel restrictions and mandating the virtual lock down of the economy. China’s policies were targets of harsh criticism, some seeing the measures as too extreme. However, those same measures became the general playbook that other countries adopted when the virus started spreading globally. The examples in Europe, including Italy, France, Germany and Spain show that done quickly and enforced strictly, lockdown measures can work to flatten the curve. The near-term economic costs were massive, but making this trade-off was almost unavoidable in order to alleviate the pressure on the health care system and most importantly, to save lives. After all, what use is an economy without healthy people. 

When China finally reopened its economy, questions swirled about how it would respond to a second wave of cases as economic activity picked up pace. An uptick in infections in June, this time in Beijing, was somewhat of a natural experiment. Chinese authorities were quick to lock down residential districts surrounding the Xinfadi market, where the new cases were traced. Travel restrictions were quickly imposed while testing capacity was scaled up extensively to support widespread testing. Contact tracing was done rapidly while positive cases were quickly isolated and treated. Agility and decisiveness were key in curtailing the spread of the virus. And for the most part, China’s robust containment regime has been remarkably successful. The number of new cases after the initial spike in early June have declined to meaningfully.

The inconvenient reality is that there are tangible economic costs associated with containing virus outbreaks. You don’t just shutter businesses and impose travel restrictions without expecting economic output to suffer in the near-term. But these costs are minimised if outbreaks are contained expeditiously and economic activity allowed to resume quickly thereafter. Importantly, the efficient containment of outbreaks by government authorities send an important signal to private economic actors, that it is in fact safe to engage in normal economic activities as the government provides a credible safeguard against public health concerns. This raises business and consumer confidence, which in some sense is already a huge battle won as the fear of the virus is itself its own poison.

China is not the only country with a proven track record of handling these outbreaks effectively. South Korea and Taiwan are good examples of countries that were able to contain the spread of the virus through a robust regime of testing, contact tracing and swift isolation of infected persons, such that they did not have to resort to locking down the economy outrightly. Strong safe management measures and a robust and well-oiled viral containment machine are more likely to mitigate the risk of a second outbreak of infections and sustain the economic recovery.

The reopening

Containing Covid-19 is instrumental in minimising the economic fallout. The US offers a good counterpoint. Engulfed in a second wave of cases, many states have had to roll back reopening measures and re-shutter certain businesses including bars, restaurants, casinos, and cinemas in order to limit the spread of the virus. This would inevitably delay the economic recovery and increase the economic blowback. Reopening safely remains crucial to ensure a quicker and sustainable recovery. In a sense, Asian economies are following this paybook, having only gradually rolled back lockdown measures and enforcing safe management policies in its place, including crowd management and mask wearing.

The good news is mobility across most Asian economies have normalised. With the exception of Indonesia, Philippines and India (recall these are the three main countries facing challenges in containing Covid-19), other Asian countries have more or less regained “full mobility.” Countries like South Korea, Hong Kong, Malaysia, Vietnam, and Thailand have regained their vigour, moving about more than they ever did before movement restrictions took root. This is indeed a welcome sign for economic recovery. Of course, set against the backdrop of potential virus resurgence across the globe, such a pick-up in mobility across Asian economies should only stoke guarded optimism. The world is not out of the woods just yet, but at the very least, we can take some comfort in the fact that Asia seems well prepared to find their way out.

The recovery

Asian economies are not just moving more – businesses are feeling a tad bit more optimistic about the future. Indeed, recent manufacturing Purchasing Managers’ Index (PMI) data offers some reassuring signs that the outlook for the crucial manufacturing sector in the region continues to be on the mend. ASEAN 5 together with China, Taiwan, South Korea, Vietnam and India saw an uptick in their June manufacturing PMI readings, compared to the previous month.

Notably, tech-heavy South Korea and Taiwan, which saw downticks in their PMIs previously, managed to print gains in June, which might signal a bottoming-out of the tech cycle that could benefit other countries that are enmeshed in the complex electronics supply chains across the region.

Malaysia and Vietnam have now joined China in having PMI readings within the expansionary zone, at 51.0 and 51.1, respectively, signalling that a majority of manufacturers see an outright improvement in the outlook.

India and Indonesia saw the most drastic improvement in PMI numbers, from 28.6 and 30.8 in May to 39.1 and 47.2 in June, respectively. Still, with coronavirus cases far from plateauing in these two countries, they face a tough road towards economic recovery. These countries notwithstanding, the upticks in PMI across Asia offer a glimmer of hope for the second half of 2020.

In terms of consensus forecasts for GDP growth, economists seem fairly optimistic as well. Asia ex-Japan is expected to lead developed markets with positive quarterly GDP growth pencilled in from the third quarter onwards. Consensus forecasts likely reflects the “first in first out” effect as it relates to the Covid crisis.

China – standing out in the time of coronavirus

What stands out is the quarterly growth projections for China, which leads almost all other countries until 2021. If anything, China is the poster child for the “first in, first out” effect. Having stemmed the spread of the virus early, they had more time to recover and implement stimulus measures. Indeed, the market is closely monitoring China’s economic recovery as it offers a preview of what a post-Covid-19 revival could look like.

China’s manufacturing and services PMI have consistently bested analysts’ expectations and rebounded from the lows of February when the economy was placed under a full lockdown. While both PMI figures have jumped back into expansionary territory in almost record time, it bears mentioning that the pace of recovery of the services sector and retail sales have broadly lagged manufacturing and industrial production. This is to be expected given that social restrictions have an inordinately larger impact on face-to-face businesses such as those operating the services sector.

The fear of contracting the virus would also impact consumer sentiment, discouraging people from engaging in social activities like shopping. Sure, some consumption expenditure might shift online, but digital apps can seldom replace the social or human experience of leisure activities which tends to encourage more spending. Nevertheless, the economic recovery in China looks promising, with consumption indicators showing signs of steady improvement. Case-in-point, China’s 6.18 shopping festival this year saw record sales pointing to a robust consumption recovery.

China’s promising economic data reflects the expansionary effect of policy support as well. The Chinese government has ramped up efforts to boost the economy, with the People’s Bank of China adopting a more expansionary monetary policy stance. This is likely to remain for some time to come to ensure a steady recovery. The government has injected a great deal of credit into the real economy, leading to a surge in credit impulse measures in the past few months. Notably, the scale of government policy support during the current Covid crisis has been far more measured than during the global financial crisis. It is unlikely that China will go all out on a ravenous credit binge circa 2009-2010. The government is likely to favour a slower but more sustainable recovery path that does not inadvertently lead to a massive credit bubble.

Like China, the growth in Asia will likely be buoyed by stronger fiscal and monetary support.

Priced in?

From the outset, stock market valuations appear stretched for most regional markets. The MSCI Asia ex-Japan index is trading at 15.8x 12-month forward price-to-earnings, close to 4 standard deviations above its historical 10-year average. In fact, current valuations are already at a 10-year high. Steeper valuations reflect in part weaker earnings expectations (the e in p/e has been falling). FY2020 earnings-per-share forecasts have been revised lower by about 6.8% versus 2019. Earnings for FY2021 is expected to rebound by about 24.6%. Even then, there is still limited clarity over earnings.  

Yet stocks are a relative game. Against global equities (MSCI All-Country World Index), Asia ex-Japan stock market valuations appear less stretched. Earnings in global markets are also expected to be more adversely impacted, with FY2020 earnings expected to decline by 15.1%, while Asia ex-Japan sees a shallower negative revision at 6.8%. Seen from a relative lens, Asia might be a cheaper alternative.

To be clear, from a house view basis, we are neutral on Asia ex-Japan stocks and equities as an asset class more generally. Within Asia ex-Japan itself, we are overweight China and Singapore markets and would engage selective opportunities in these markets as valuations are not particularly compelling.

Key themes

In terms of selective investment themes within Asia, we continue to favour new economy stocks as online engagement becomes more entrenched in a Covid-inflicted world. The pandemic has already accelerated the shift from offline to online channels and this structural trend bodes well for internet players with deep e-commerce penetration and market leaders of digital adoption. These companies are best positioned to gain market share. 

Indeed, an increased awareness of health issues and home economic effects of social distancing measures in the time of Covid-19 have benefited healthcare and tech stocks the most, with both sectors clocking impressive gains year-to-date and significantly outperforming the broader MSCI China index. In view of the already strong performance of these sectors, stock selection will matter greatly.

In Hong Kong, we are attentive to the prospect of secondary listings of Chinese American Depositary Receipts (ADRs) (for example stocks like Baidu, Trip.com, Yum China, Alibaba etc) in view of prolonged US-China tensions and the potential enactment of the Holding Foreign Companies Accountable Act (HFCAA). The law requires foreign companies listed in the US to disclose if they are owned or controlled by a foreign government and prohibits the securities of a company from being listed on any US exchanges if the company fails to comply with the Public Company Accounting Oversight Board’s (PCAOB) audit 3 years in a row. Its onerous terms have raised concerns about the potential delisting of Chinese ADRs.

To circumvent these regulations, Chinese companies listed in the US might seek alternative listings. Hong Kong could well emerge as a preferred option in light of the convenient conversion between ADRs and shares in Hong Kong, the shorter listing process and fewer disclosure requirements compared to primary listings. Secondary listings could serve as re-rating catalysts for the qualified ADRs as it mitigates de-listing overhangs and increases access to onshore Chinese investors through stock connects.

This is welcome news for the Hang Seng Index, which had recently announced specific reforms to expand the types of companies that would be eligible for inclusion into the index. These include companies with a weighted voting rights structure and secondary listing stocks. Potential inclusion into a major index might be a plus factor for ADRs to list in Hong Kong. This would be a positive change for the Hang Seng Index, which has been weighed down this year by the dominance of the financial sector in its constituent mix. A more diversified mix reflecting dynamic new economy names and growth stocks might drive a re-rating of the index. Developments on this front might make an appealing case for investing in Hong Kong.

The risks

Nevertheless, there are risks we need to consider when investing in Asia ex-Japan.

Where China and (increasingly) Hong Kong, are concerned, investors should be mindful of further escalation in US-China tensions which would inject more volatility into the markets. As it stands, tensions between the two superpowers have rapidly broadened in scope, to include investments, health care and tech issues. We might have begun the year with a promising US-China trade truce, but the lasting effect of this ceasefire is already in question. As the past few months have shown, trade is but the tip of a huge geo-political iceberg.

As we move closer to the US presidential elections in November, political rhetoric targeting China might intensify. After all, adopting a tough stance on China shares bipartisan support, especially if you consider that a record proportion of Americans on both sides of the political spectrum harbour unfavourable views of the country. What is concerning is that political rhetoric is slowly starting to become policy. The House and the Senate have started to pass legislation to curb China’s influence be it targeting ADRs or Hong Kong, while the US Commerce Department has introduced various export restrictions to stifle targeted Chinese businesses like Huawei.

As President Donald Trump puts it, US-China relations are “severely damaged.” It seems rather farfetched to expect a Phase Two trade deal when tensions are as fraught as they are right now. The ratcheting up of US-China tensions will trigger a more volatile market environment.

Meanwhile, border skirmishes between China and India that have resulted in casualties, and rising tensions in the Korean peninsula are other political risks to look out for. These come at the most inopportune time for growth as economic conditions remain fragile especially in the face of potential second waves of Covid-19.

These risks are of particular concern because stock market valuations are not categorically cheap. At 15.8x 12-month forward price-to-earnings, valuations of the MSCI Asia ex-Japan index are getting stretched, trading more than 3 standard deviations above the past 10-year, 7-year and 5-year historical averages. The margin for error is admittedly compressed and the bar for outperformance is certainly higher given that we’re no longer working off a low base. That is not to say that there is a dearth of opportunities. Stock selection and holding power will matter a great deal in this case.

The risk of government intervention is yet another factor to be wary of. Depending on the circumstances, China’s central government might be an investor’s best friend or worst enemy. This dysfunctional relationship was in full display over the past week. The Chinese government, through the state-run media, had talked up the market, encouraging retail investors to buy stocks. The government discussed the prospect of a “healthy” bull market and how investors could look forward “to the wealth effect of the capital markets” in a front-page editorial for the China Securities Journal. Unfettered optimism led the CSI 300 index up 18% in a little over a week. Days later, concerned by the speed of the rally, Chinese authorities again took to the press to warn about the dangers of a “crazy” bull market while government-owned funds announced plans to trim holdings. It is clear from recent actions that the Chinese government is seeking to engineer a steady bull run and avoid repeating the mistakes of 2015 when market cheerleading ignited a speculative frenzy which resulted in a stock market bubble that ended in a costly crash. The government’s recent editorial intervention led to a 1.8% and 2.0% retreat in the CSI 300 and Shanghai Composite indices respectively.

The episode underscores the vulnerability of the market to speculative frenzies. To be clear, this is not just unique to China, but the heavy handedness of the government in steering the market is certainly a valid concern. It adds another layer of uncertainty.

In addition, unlike most other major markets, retail investors account for the lion’s share of local stock trading in China which has been prone to extreme swings in sentiment that can have ripple effects on the economy and monetary policy. The scale of the market’s boom and bust and the government’s fumbled response in 2015 is a cautionary tale for investors. Admittedly, the market is far from a 2015-like bubble, but these are risks that should not be overlooked. Ultimately, chasing unsustainable sentiment-driven rallies which are egged on by government verbiage and unsupported by fundamentals is a recipe for disaster.

The approach

Given these risks, there are a few points investors should note when engaging opportunities in Asia ex-Japan.

In an expensive market, passive strategies might not work to capture the full potential of investment opportunities available. Stock picking and active management becomes crucial to earn better risk-adjusted returns, navigate potentially choppy markets, and capture promising opportunities within the region.

By region, it necessarily implies diversifying country exposure. Asia ex-Japan consists of more than just China and Hong Kong markets. There are plenty of investment opportunities looking to be mined in other underperforming markets within this continent, including Malaysia, Thailand, Indonesia, Singapore, and many others. An actively managed fund with eyes and ears in these markets might be more plugged in to potential bottom-up investment ideas and may be better suited to capture the full breadth and depth of investment opportunities in the region.

Also, focus on income. The bar for investment returns via capital appreciation is admittedly elevated at this point given steep valuations. The low hanging fruit where returns are concerned is investment income. Dividends from stocks and coupons from bonds are among the key sources of such income and they will play a greater role in boosting total portfolio returns against the current investment backdrop. Admittedly, dividends might be cut in view of the weak earnings environment, which is a prudent measure in managing capital. In this case, investors should take a longer-term view and look for companies which are able to pay out sustainable dividends when economic conditions recover.

In this case, do not just focus on stocks. Expand the search for opportunities to fixed income as well. The current credit spread based on the Bloomberg Barclays Emerging Market High Yield Bond index is still some distance away from its 10-year historical average, which suggests some potential for further spread compression. This is especially given the low interest rate environment that is expected to persist for a significant period of time, which has already triggered an active hunt for yield. As such, Emerging Market High Yield bonds remains our favoured asset class to express risk-taking as we expect high yield bonds to continue to benefit from this structural driver. More specifically, we like Asian high yield bonds for their attractive valuation, healthy yields, and better economic fundamentals.

Still, investors should be wary of the risks and invest selectively in this segment of the market. Some of the risk factors to look out for include:

  • The re-escalation of US-China tensions that might disrupt the current market momentum;
  • Worsening geopolitical sensibilities across Asia following recent skirmishes between China and India and increased tensions in the Korean peninsula;
  • Secondary waves of Covid-19 infections across the world which might set back economic recovery across the world; and
  • Elevated corporate defaults and bankruptcies across emerging markets.

Lastly, when investing in Asia ex-Japan, focus on the long game. Investors should recognise that the long-term growth story in China, and Asia more broadly, remains intact. This will continue to play out long after Covid-19 has receded from recent memory. The shift towards consumption-led growth coupled with the move towards high-skilled and information and technology intensive industries are long-term secular trends that will only gain traction with time as Asia climbs the development ladder.

Yet, while Asia is pregnant with long-term promise, it is also troubled by near-term risks. As such, investing through a diversified mix of asset classes (i.e. stocks and bonds) and country exposure is a useful strategy to engage these long-term opportunities while still mitigating downside risks. Active management is useful to improve agility during periods of heightened market volatility.