Outlook 2017: Asia ex Japan equities
Select long-term opportunities are still present in the region as we prepare to "expect the unexpected" in 2017.
Unstructured Learning Time
- High valuations attributed to most Asian consumer stocks on the basis that they will have ‘safe’ earnings growth into perpetuity are misplaced
- State-led fiscal spending in China will be negative for its stockmarket in the medium and long term
- With yield still in short supply, we are focusing more on office property in constrained markets like Hong Kong and telecoms names in developed markets
The most recent set of Asian earnings results produced few surprises with the general picture of sluggish, though not necessarily deteriorating, demand prevalent in most industries (whether domestic or more export-oriented).
The exception to this was a few infrastructure and commodity-related sectors in China where the latest credit-driven sugar rush is providing what we expect will be a short-term, and ultimately futile, stimulus. Most of the headwinds we are seeing are widespread across Asia despite the high hopes of many Asian strategists.
Recent visits confirmed, for example, that like many in the region Philippines consumer stocks are suffering from rising competition and weaker-than-expected end demand, as the trickle-down effect of relatively strong economic growth remains patchy.
With challenges compounded by the shift in consumption patterns seen among millennials (who are clearly not responding to traditional advertising and brands), we think the high valuations attributed to most Asian consumer stocks on the basis that they will have ‘safe’ earnings growth of 10-15% per annum into perpetuity is misplaced.
In general, we find the growth and quality premium in Asian markets hard to justify, while much of the rest of the market remains unattractive due to poor corporate governance and a lack of focus on the creation of shareholder value.
Near term Chinese growth to be supported by government stimulus drive
Chinese economic growth, in the short term, will be supported by the current government-driven infrastructure stimulus. This is a very typical Chinese stimulus in that it is state-owned enterprise (SOE) led, and is funded directly or indirectly by the banks – whether it be via the large scale issuance of wealth management products, or by the dubious and increasingly popular public private partnership (PPP) schemes the local governments have devised to keep debt off balance sheet.
This is giving the Chinese economy a short-term sugar rush but we view this as temporary. For the Chinese stockmarket, the stimulus is negative in the medium and longer term as more wasteful investment means more destruction of capital and more bad debts.
China to follow Japan 1990s model in the longer term
We now expect that, like Japan post its bubble, the Chinese government will use periodic fiscal stimulus packages to offset a sluggish and deflation-prone economy. This will lead to a rapid accumulation of government debt. The only difference being that the Chinese authorities may pretend the debt is held in the private sector, via the SOEs and Local Government Investment Vehicles (LGIVs), whereas it is quite clear that the large and accumulating bad debts in the banking system will end up on the government’s balance sheet.
The lack of reform and serial bubble-blowing means long-term vulnerabilities are rising. PPPs are just a more distorted version of LGIVs and the cement and steel consumption charts we have flagged so many times just reiterate this is among the biggest bubbles we will see in our investment careers.
Turning to more recent events, the latest bout of US dollar strength post-election has been driven by hopes that President-elect Trump’s proposed mix of policies (tax cuts, deregulation, infrastructure spending etc.) will be reflationary1 for the US economy and lead the Federal Reserve (Fed) to hike rates more aggressively. This will have conflicting influences for Asia ex-Japan markets.
The feedback loop from a stronger greenback and higher US rates will tighten domestic liquidity in Asia and this will hurt unhedged dollar borrowers. Likely outflows of ‘hot’ money – as we have seen recently, will pressure Asian currencies, domestic bonds and stockmarkets.
However, unlike in past periods where tightening policies were to slow growth and constrain inflation, we are now talking about the Fed withdrawing stimulus in response to accelerating growth. That is, moving from a period of sub-par growth and dis-inflation in the US over the last few years towards a more ‘normal’ environment of healthier US investment and consumption.
If this does come through (still a big IF in our view) then this stronger growth backdrop could actually see US trade deficits expanding again, Asian export growth picking up and an improved flow of US dollars into Asia through these channels – which would be positive for many Asian companies and industries.
Trump unpredictability and mixed macro backdrop
What does this mean for the funds? We continue to focus on technology companies in the right areas with technology leadership (vision, acoustics, semiconductors), and tread very carefully in the consumer space, especially retail where we only think convenience stores and selected fashion brands/suppliers focused on fast fashion and new fabrics can do well.
We stick with the internet winners who are supplying the platforms and content for the experiences (and services) that are set to become increasingly sophisticated and, for customers, time consuming.
The trickier question is what to do with our property and telecom stocks, both of which face challenges in our brave new world. With yield still in short supply and question marks still in our minds on the likelihood of sustained reflation we think we stick with them but focus more on office property in constrained markets like Hong Kong and in the telecoms space focus on the developed markets that have consolidated and moved to a predominantly postpaid model (i.e. monthly fixed charging with limits on data usage).
Other sectors we continue to intrinsically like are healthcare and selected branded manufacturers that are playing on lifestyle trends (cycling) or can use new technologies to materially improve and broaden their products (power tools, auto-electronics). We remain cautious on Asian banks, particularly those in North Asia (China, Korea, Taiwan) where we think significant bad debt continue to be “evergreened”.
We also don’t think commodities stocks are attractive. As mentioned earlier, commodity usage (especially cement, steel and coal), are particularly driven by the property and infrastructure bubble in China (by far the most commodity-intensive sector globally) meaning structural caution is warranted here. It also should be noted that outside of Australia serious ESG (Environmental, Social and Governance) issues abound in the commodity space in Asia.
All in all, we think the macro environment is impossible to predict, so investors should instead focus on the long-term fundamentals of companies and the industries in which they operate. As we turn the page and look at the new year ahead, and given the market reaction to the supposed Brexit and Trump “disasters” in 2016, how we plan to deal with macro issues in 2017 can be summed up as simply: expect the unexpected.
1. Fiscal or monetary policies that are designed to expand a country's output and curb the effects of deflation.↩