This article first appeared in Personal Wealth, The Edge Malaysia Weekly on January 29, 2018 - February 4, 2018

Emerging markets (EM) in Asia, and Asian equities in particular, look set to be an attractive play this year. According to a report by global investment firm KKR, titled Outlook for 2018: You Can Get What You Need, released earlier this month, while 2017 was a stellar year for the likes of China and its Southeast Asian counterparts, “emerging market outperformance still has three to five years more of running room”.

“Indeed, our recent travels lead us to believe that domestic consumption stories are accelerating in many areas of EM, which we believe will continue to drive a sustained period of overall economic growth.

“Meanwhile, smaller deficits and higher real rates give us additional confidence that the EM tailwind can withstand macro shocks, including a tactical rebound in the dollar, along the way. Finally, we still think that investors are underinvested in EM, which should continue to attract flows as retail and institutional investors are poised to reposition their portfolios.”

KKR targets overweight positions for public and private equities in Asia for several reasons. The region’s surging middle class and strong productivity trends are signals of good structural growth for the foreseeable future. The continent’s rapidly urbanising population also means that overall gross domestic product per capita in the region is growing at a much faster rate than in many other parts of the world. This bodes well for consumer financial services, payment processing, education and healthcare delivery. KKR expects these sectors to see upward trends for earnings and multiples over the next few years.

KKR chalks this up to improving returns on equity, accelerating momentum and appreciating regional currencies.

“While valuation is no longer as compelling as it was once in emerging markets, return on equity is improving and currencies are appreciating. We are constructive on emerging market equities and local government debt, but less so on emerging market corporate debt,” the report says.

Valuations in these emerging markets are now neutral, rather than cheap. Equities are trading at a 5.6-point discount compared with their developed market counterparts, and KKR acknowledges that valuations are less compelling than the 7.3-point discount it saw at the end of 2015.

Nonetheless, the report contends that operating margins are improving across emerging markets and boosting returns on equity. This is helped along by the fact that financial leverage across emerging markets is declining, while asset turnover remained nearly unchanged in recent quarters.

“With emerging markets appreciating 38% in 2017, we fully acknowledge that last year was a huge year for emerging market performance. As such, we do expect some backfilling during parts of 2018,” the report notes.

“That said, we think that this bull market is secular, not cyclical, and we are willing to endure some short periods of underperformance to stay invested in what we believe is one of the more compelling macro themes that we see.”

Further boosting emerging market equities is foreign exchange numbers. “Forex momentum has improved, and we think prospects are good that forex will not be as much of an obstacle to emerging market equity returns in the future (even with the dollar bounce we are expecting at some point in 2018).”

As for China, KKR believes that real GDP growth will decelerate 30 basis points to 6.5% on the back of a cooling housing market, more modest infrastructure spending growth, increased anti-pollution measures and additional supply-side reforms. However, these headwinds will be partially offset by consumer confidence, given that the job market is tight and wages are rising.

The report says among the sectors in EM to look out for include consumer tourism, leisure, health and wellness, consumer financial services, payment processing and education.

These sectors are becoming market share gainers in this part of the world, as opposed to the necessities that once dominated the budgets of Asian consumers. “Within emerging markets, we generally favour economies with large domestic consumption stories and/or increasing value-added service franchises. At the moment, India, Indonesia, Vietnam and even parts of China appear compelling,” the report says.

“Our view is that mobile shopping and online payments are accelerating this trend, which leads us to believe that this shift is occurring in both developed and developing countries.”

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.