Investing: Bright outlook for Asian equities despite uncertainties

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on June 25, 2018 - July 01, 2018.
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Geopolitical tensions and rising borrowing costs due to higher US interest rates are among the factors that are causing volatility in Asian equity markets this year. Nevertheless, Andrew Gillan, head of Asia ex-Japan equities and co-manager of Janus Henderson Investors’ Asian Growth Strategy, believes that the long-term prospects of investing in the Asian equity markets are still intact.

While the returns may not be as high as last year, the region has attractive demographics and is seeing rising consumption and strong economic growth. These factors can help the region weather the uncertainties.

“We are very much in the optimistic camp for the next three to five years. We were very happy to enjoy the 35% to 40% return in Asian equities last year and obviously, clients and investors have to be realistic that we are not going to have many years like that in succession. It is natural that things will take a breather this year. But we think the trends going forward will be very positive for Asia and Asian equities,” says Gillan.

In the meantime, there will be short-term volatility due to local political events, such as the upcoming elections in India, and weaknesses in the global markets. “Politics is going to set the tone. China’s economy will continue to see a gradual slowdown. But the structural story is still based on the bottom-up. Corporate earnings recovered by 20% in Asia last year and we are expecting 12% or 13% earnings growth this year,” says Gillan.

“If companies can deliver that earnings growth, then I see the markets staying at the current level or higher for the rest of the year. If we start seeing corporate earnings fall, then it will put pressure on the market.”

Emerging-market equities saw a heavy sell-off in April and May, with US$8 billion flowing out of Asia, according to the Institute of International Finance. In Gillan’s view, the foreign selling of emerging-market equities was mainly driven by weaknesses in countries such as Argentina, Brazil and Turkey. Brazil has been facing labour unrest while Argentina sought help from the International Monetary Fund last month to avoid a financial crisis.

“The issues they have illustrated are exactly what we do not have in Asia. We do not have countries with very weak fiscal positions or very high levels of foreign debt,” says Gillan.

“If we look at the current account positions in India, Indonesia or the Philippines, where the currency is the weakest in Asia, their year-to-date current account deficit is less than 2% of their GDP, which most economists would say is pretty healthy. Their fiscal positions are much stronger than they were back when tapering began.”

Asia accounts for more than 60% of the benchmark MSCI Emerging Markets Index, which is seen as a risky asset class. However, Gillan believes that Asian countries, such as China, have strong balance sheets and should no longer be included in the category of emerging markets.

“If I were a global investor, I would be saying, ‘Well, I want that Asia allocation, but I don’t necessarily need the Latin American, Eastern Europe or African allocation that comes with it. So I think this, together with the MSCI China A-shares inclusion, could well be the start of Asia decoupling from emerging markets and becoming an asset class in its own right,” he says.

Close to 230 China A-shares were added to the MSCI’s emerging markets benchmark last month, with more to be included in August.

Another factor weighing on Asian equities is the possibility of a US-China trade war provoked by US President Donald Trump. However, if a trade war breaks out, Gillan believes that the impact could be offset by the strong domestic consumption in China and trade between Asian countries.

“If I look at the overall Chinese economy, how significant are its exports to its GDP? Not as significant as you may think. It is more of a domestic story. That is why the government is very careful about the stimulus that they have. And if we do see an escalation in a trade war, there will be big repercussions for US and European companies that want to grow in China,” he says.

Many US corporations such as Starbucks and Boeing plan to expand in China because it is the biggest growth market. So, the US may have to be more wary of imposing huge tariffs on China.

China will continue to be a strong factor in driving the performance of Asian equities, with returns broadening beyond the large-cap technology stocks. In Gillan’s Asian growth fund, China has the biggest allocation of close to 24% of the portfolio. But it is still underweight relative to the benchmark index, which has an allocation of about 30%.

Gillan expects funds to flow into the region due to the recent inclusion of China A-shares on the MSCI indices. The Chinese government’s initiatives to reduce debt levels and stabilise the economy also give him confidence in the market.

“I am more positive on China at the moment than I have been over the last three to five years. And the reason for that is it has a lot of political stability,” says Gillan.

“Obviously, President Xi Jinping has secured and strengthened his position, but all the policies he is adopting are very sensible. He understands that deleveraging has to be a focus, but he is trying to do that in a way that will not have a negative impact on both the stock market and the real economy.

“At the moment, it is a balancing act. However, it seems to be quite effective in terms of implementing the policies and still sustaining relatively good growth numbers.”


Where is the growth in 2018?

The growth in Asian equities last year was driven by China and tech companies, namely South Korean memory chip companies and Chinese internet companies such as Tencent and Alibaba, Gillan observes. This year, the tech players are expected to perform, albeit with more mixed results. The earnings recovery this year, however, will extend to cyclical stocks and the financial sector.

“The performance will broaden out to different areas of the economy. Banks will be an important area from which we will benefit. In Malaysia, it is Public Bank. In Singapore, it is DBS Bank,” says Gillan.

“The recovery has moved from the tech sector into the more economically sensitive ones. The consumer sector is a bit challenging because it depends on the market and level of competition. But even there, you have seen stronger share price performance from some consumer stocks that underperformed last year.”

The rising interest rate is a factor that will improve the banks’ bottom line. This bodes well for the banks that have been seeing thinner margins due to quantitative easing in the last three or four years.

“If US interest rates start to rise, typically you will see Singapore and Hong Kong bank rates go up and obviously, the lending rates will go up faster in a more pronounced basis. Banks have been operating on the thinnest margins because their deposits are obviously very low, and their lending rates have been lowered as they are being really competitive. So, the fact that banks can increase their lending rates to maybe 25 or 50 basis points brings a lot of leverage,” says Gillan.

The strength of banking stocks is also seen in Malaysia with Public Bank, despite the uncertainties associated with the recent change in government and the weak ringgit. Investors are still waiting to see how the new government will cover the shortfall left by the abolishment of the Goods and Services Tax, says Gillan.

“How are you going to replace those revenues going forward? The government’s coalition is formed by political parties that have recently started working together. So, I think it is right to retain some scepticism until we see delivery of the policies,” he adds.

“As for Public Bank, if you look at the way it has been managed before, during and after the 1997/98 Asian financial crisis, it is one of the strongest banks in Asia, is very conservative, very well capitalised and gives a good dividend yield.”

Tech stocks, on the other hand, will deliver mixed results due to events such as Apple’s underwhelming sales growth of its new phone in the first quarter. Gillan’s fund was overweight on tech stocks last year but this year, it has reduced its exposure to the sector by 3% to 4% and reallocated funds to banking stocks.

There are still opportunities in tech stocks in Asia, where valuations are not too high and earnings growth is still on a compelling trajectory, Gillan observes. For instance, in the first quarter, Tencent crossed the threshold of one billion monthly active users, reflecting plenty of opportunities for growth.

“So, our big worry is if the profit growth does not come through or the return on equity declines with these stocks. But structurally, tech is still where we will overweight for the next 5 to 10 years because there is still a lot of disruptions going on,” he says.

“We are seeing disruption in the telecommunications sector and we have seen it in retail with online retailing and the Amazon effect. I think we will see it in financials and consumer stocks. My attitude is more to back the disruptors that are growing at very strong levels with good customer basis rather than companies that are being disrupted.”