Some clarity amid clouds of uncertainty

In a serendipitous turn of events, the case for investing in Asia ex-Japan has become somewhat firmer owing to two key developments that transpired over recent weeks.

Recall that market jitters since October this year have been provoked by two key concerns, namely:

1. Uncertainty over the speed and the end-destination of interest rate increases by the Federal Reserve and
2. Escalating US-China trade tensions that was seemingly darkening companies’ earnings outlook.

Speculations on a possible easing of these concerns has conversely led markets higher. Indeed, optimism on the back of dovish fed speak and hints of a possible agreement in the lead-up to the Trump-Xi meeting stoked bullish sentiments in the week ending 30 November.

Fast forward a week later, investors may have found some clarity, reducing these uncertainties.    

1. The return of the doves

First, Federal Reserve Chairman Jerome Powell walked back his “long way below neutral” comment in a speech on 28 November at the Economic Club of New York. His initial off-the-cuff comment stoked concerns of an extended path of interest rate increases which unsettled and unnerved investors. In a well-considered and somewhat extensive speech about financial stability, Mr Powell delivered a phrase that sent the bulls charging back into the markets: interest rates, according to Mr Powell, were “just below” neutral. The market interpreted the shift from “long way below neutral” to “just below” neutral as a dovish-tilt in policy guidance. It likely meant that interest rates, while on an upward trajectory, need not have to rise all that much to reach levels that would keep the US economy on an even keel.

Indeed, just a day before his scheduled speech, Fed Vice Chair Richard Clarida had softened the ground, characterising the level of interest rates as being “just below the range of longer-run estimates” of neutral. Fed Chair Powell’s seemingly cautious speech the next day provided the water for dovish bets to grow.

More importantly, in recent speeches, Fed officials seemed to favour a more data dependent approach to setting policy, as opposed to the almost mechanical quarterly rate hike that has been the Fed’s playbook for the past two years. With policy makers in the dark about the exact level of the neutral rate and armed only with a range of estimates to guide policy making, it seems sensible to favour a more flexible approach when deciding on interest rates.

As it is, the core Personal Consumption Expenditure inflation is hovering around the Fed’s target and upside risks to inflation seem contained for now, providing some lee way for a wait-and-see approach when it comes to policy. Markets are especially dovish, pricing in only one rate hike in 2019, versus the Fed’s 3 rate hike guidance based on their September dot plot (Chart 2). Whether we see a dovish alteration to their December dot plot remains to be seen. Should the median expectation of the number of interest rate increases decline, markets may climb on the most concrete evidence yet of a more dovish Federal Reserve.   

A shorter distance of increase and a slower pace of rate hikes provide less scope for substantial strengthening of the US Dollar from current levels. The growth and policy divergence theme may not be as supportive of US Dollar strength in view of the steadily fading US fiscal stimulus and peak policy tightening. Of course, one could always argue that the US Dollar may continue to be propped up by safe-haven flows as was the case this year in the thick of the US-China trade conflict. Yet, a seemingly unexpected development over the weekend of 1 December may have put a lid on such pressure.

2. US-China tensions ease

On 1 December, over an assuredly sumptuous steak dinner at the G-20 summit, President Trump and President Xi agreed to a temporary ceasefire in the on-going US-China trade war. The US President agreed to hold-off on imposing any additional trade tariffs, including the planned increase in tax rates on US$200 billion worth of Chinese imports from 10% to 25% previously scheduled for 1 January, as both countries engage in intense negotiations over the next 90 days to formalise a comprehensive agreement on their broader trading relationship.

This includes finding solutions to many lingering thorny disagreements related to forced technology transfer, intellectual-property theft, non-tariff barriers, cyber-intrusions and cybertheft along with other associated barriers in the trade of services and agriculture. 90 days for an agreement is a tall order considering that eliciting concessions on seemingly non-negotiable issues related to China’s strategically important industrial policies would take far more than three months to resolve. 

Of course, President Trump’s generosity did not come cheap. In exchange, China has agreed to make a "very substantial" purchase of a range of US goods, including immediate purchases of US agriculture, in an effort to narrow the trade deficit. Notably, China had not made any truly meaningful concessions during this meeting. After all, just 10 days before the fateful dinner, US Trade Representative Robert Lighthizer pointedly lashed out that China has not changed its “unfair, unreasonable, and market-distorting practices” since the Section 301 investigation. And indeed, the pledge to significantly increase imports from the US was the same offer made in the now defunct deal that was brokered by Commerce Secretary Wilbur Ross in May.

The 90-day time frame established by the Trump administration means that a deal must be reached by early March next year which, coincidentally or not, occurs around the start of China’s annual national legislative session. As this event is often a show of government strength, Chinese leaders may be wary about the optics of making concessions to foreigners. This would heighten the stakes even further, especially since the White House has made it abundantly clear that they would increase existing tariffs on US$200 billion worth of Chinese imports from 10% to 25% and possibly add tariffs on the additional US$267 billion worth of imports if the negotiations fail to bear fruit.

To be clear, existing duties will remain in place during the duration of the talks, but the threat of further escalation has been delayed for now. As it stands, the US has imposed 25% tariffs on US$50 billion worth of Chinese imports and 10% on another US$200 billion.

Another concern is whether the US will honour this broad framework. As it is, a deal was supposedly struck in May, but that only lasted a few weeks before the Trump administration announced 25% tariffs on US$50 billion worth of Chinese imports. Past experience would suggest that the ceasefire agreement itself might be fleeting. The difference this time is that President Trump – not Wilbur Ross - had personally brokered the deal with President Xi. The hope is that some kind of deal may be forthcoming especially considering the two presidents’ personal stake in this round of negotiations.

Also, as it stands, there is some ground for optimism. The Chinese government has already corroborated the broad outlines of the US’ stipulated conditions for the trade truce including the 90-day period for negotiations. The seemingly divergent understanding of the terms of the truce following the meeting had initially caused confusion in the markets and stoked concerns about the durability of the agreement.  At the same time, the Chinese government has publicly stepped-up efforts to boost intellectual property enforcement, improve market access to foreign firms and reduce barriers to foreign investment.

When it rains, it pours

Through sheer serendipity, these two consequential events occurred but days apart from each other. And in the spirit of the upcoming holiday season, Asia ex-Japan received two important gifts in the form of a (1) more dovish Federal Reserve and (2) some easing in US-China trade tensions, even if temporary. If anything, the near-term outlook seems less cloudy.

As detailed in an earlier report, Asia ex-Japan continues to exhibit resilience against a series of external pressures. The region is helped by a steady improvement in domestic policy management, with the fruits of its efforts handily captured in improved rankings in surveys of international competitiveness. In addition, as can be gleaned from Chart 3, major ASEAN economies have been clocking around a 5% growth rate, the average since 1990, despite escalating external pressures.

While growth prospects seem sound, the region has received very little love from investors this year, with valuations mercilessly clobbered since June. As it stands, the MSCI Asia ex-Japan index is trading at a blended forward Price-to-Earnings of 11.6x (as at 6 December), about 1 standard deviation below the past 5-year average and 0.6 standard deviations below the past 10-year average.

Compared to other developed market regions – with the exception of Japan - Asia ex-Japan stands out as among the cheapest markets around on the basis of Price-to-Earnings comparisons vis-à-vis their historical long-term averages.

Meanwhile, the earnings backdrop in Asia remains encouraging as well, with earnings growth projected to grow at about 9% in 2019.

Collectively, these factors support our bullish view on Asia ex-Japan equities.

Attractive opportunities, but manage the risks

Nevertheless, we continue to emphasise the need to manage risks even if the investment backdrop appears more constructive. First, the politics underlying the US-China trade negotiation is inherently unpredictable. History is littered with many examples of false starts and fragile settlements. Importantly, a temporary truce should not be mistaken for a permanent resolution. The issues between China and the US extends beyond just trade, but trade may well be used as a pawn to get concessions on other issues of more geopolitical importance.

Indeed, the path towards a binding resolution is paved with challenges. Just last week, markets trembled on the back of increasingly aggressive rhetoric between US and Chinese officials following the surprise arrest of the Chief Financial Officer of Chinese telecoms group Huawei, on charges of violating US sanctions. The arrest heightened concerns that “Tech Wars” were possibly supplanting “Trade Wars”, which in turn may jeopardise the progress of current trade negotiations. Whether these will be regarded as two mutually exclusive issues, or potentially be conflated with each other, remains to be seen. It’s only political guesswork from here.

Also, as it stands, from the US perspective, a divided Congress may throw up episodes of potential instability with the debt ceiling increase and budget ratification used as potential political gambits to elicit concessions, whatever they may be. Recent history seems peppered with such episodes. We shouldn’t discount too much the wisdom of politicians not to repeat such tried and tested strategies when backed to a corner.

On monetary policy, a more measured pace of rate hikes should neither cloud the fact that interest rates are still heading higher nor diminish the material concerns surrounding the shrinkage of the Fed’s balance sheet in the background. Across the Atlantic, the European Central Bank is set to end quantitative easing, removing a key source of liquidity in global markets. Meanwhile, a number of other central banks including the Bank of Canada and Bank of England are moving to increase interest rates. On an aggregate basis, financial conditions are set to tighten as the process of policy normalisation take root on a broader geographical level.

In addition, it’s important to recognise that the dovish path of interest rate increases is predicated on stable and on-target inflation. Yet, we should be mindful of upside inflation risks considering that the US economy continues to operate at full capacity. Wage growth has already shown nascent signs of acceleration and in time, may pressure inflation higher. Any incremental inflationary pressure would invite a faster pace of rate increases as the Fed seeks to temper economic activity. After all, policy is not on a pre-set path. There’s as much probability that the Fed will act swiftly to curb inflationary pressures, as there is for the Fed to loosen policy otherwise.

Indeed, such policy and political developments may invite more turbulence ahead, especially on the back of a moderating growth backdrop. Higher volatility in 2019 is the rule, not the exception.

Take a diversified approach to Asia ex-Japan

On balance, on the back of attractive opportunities in Asia and in view of the attendant risks, active and multi-asset portfolio strategies might be useful to navigate a choppy investment terrain ahead whilst allowing the investor to be nimble enough to capture potential returns as when opportunities arise. 

Ultimately, active managers are better able to leverage the efforts of fundamental analysts on the ground, who can enhance the discoverability of investible information and provide a more nuanced and deeper understanding of actual domestic conditions. This in turn provides some competitive advantage that can result in long-term outperformance versus passive strategies, especially in markets that are less transparent.

A unit trust solution can meet the needs of bottom-up security selection, asset diversification as well as active management. This can offer investors some peace of mind when investing the long-term potential of this region amidst an admittedly turbulent and inherently unpredictable time.