BlackRock 2019 Asia Investment Outlook

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Structural reforms likely to continue for Asia Pacific region.

BlackRock investment professionals have set out their investment outlook for 2019 on the Asian equities and credit markets.

  • The year 2019 could be this year’s mirror image when risk assets declined as many countries faced external headwinds amid a strong backdrop for earnings and economic growth globally.
  • The Asia Pacific region leads the emerging world in structural reforms, and we believe this trend will likely gain traction next year as countries turn more attention to internal matters.
  • For the first time in years, cash has become an attractive asset class, but a change in investors’ risk appetite could boost risk assets. Markets in Asia Pacific may benefit due to current valuations and fundamentals.
  • Main risks to our outlook could be a strong deceleration of global growth or intensification of geopolitical risks, but a reasonable growth pace and rationalization of US-China trade tensions is our base case.

Belinda Boa, Head of Active Investments for Asia Pacific and CIO of Emerging Markets, Fundamental Active Equity:

The year 2019 could be this year’s mirror image. In 2018, strong earnings and economic fundamentals prevailed, while restrictive policies and geopolitical uncertainty hurt investor sentiment and asset returns in most of the world. In 2019, such policies are likely to ease, along with geopolitical tension and inflationary pressure as the global economy enters a decelerating – albeit still expansionary ‒ phase, and risk assets may rally amid slower economic and earnings growth.

This year’s underperformance of risk assets in non-US markets correlates with a shift in investors’ mindset, triggered by multiple factors. The rise of US interest rates increased the appeal of US dollar-denominated assets, boosting prices and the dollar itself. The higher cost of servicing dollar debt exposed vulnerabilities of countries with large current account deficits. Pressure to raise interest rates went up, especially in emerging markets, not to prevent economies from overheating but to protect their currencies. At some point during the year, the legal tenders of Turkey and Argentina had lost about half their value against the US dollar and one quarter for Brazil and South Africa. These countries were outliers, but fear of contagion to other emerging markets set in. Also, rising oil prices and trade tensions with the US, especially the US-China trade relationship, caused investors to turn bearish even as broad fundamentals remained strong. What could be next?

The global economic cycle is maturing and the uncertainties investors grappled with this year will not vanish overnight. It is impossible to predict the growth trajectory in the next three-to-six months, but global growth is likely to moderate over the next few quarters. This is not necessarily bad because the downswing of a cycle corrects excesses built in the upswing, and this helps to avoid bubbles. What investors forget sometimes is the reason they have invested in financial assets. Often it is to satisfy spending decades into the future, as the case is for pension plans or individual retirement accounts. Thus, the daily news flow and near-term market gyrations matter little over their investment horizon.

A possibility in 2019 is that in an environment of decelerating growth, policy becomes less restrictive, trade tensions lessen, and risk assets rally. Let’s, however, revisit the bigger picture. The Asia Pacific region is considered the world’s growth engine, and this is unlikely to change over the foreseeable decades. Economic growth is fuelled by productivity enhancements and an abundant supply of qualified workers entering the labour market. Both of these abound in Asia Pacific. Living standards should be significantly better for many people five, ten, twenty years from now. This trend is not captured in the day-to-day news flow, but we believe it will undoubtedly bring significant investment opportunities over time. This makes us bullish on assets from Asia Pacific.

Andrew Swan, Head of Asian and Global Emerging Markets Equities: The year 2018 was a classic example of investor sentiment driving near-term asset returns. The multi-year, above-trend global economic recovery and related equity rally that sent stocks to all-time highs on January 26, diverged afterwards even as corporate and economic fundamentals remained strong in most countries. The US economy benefited from fiscal stimulus and tax reform, while tighter monetary policy sought to balance inflationary risks in the near full-employment economy. This boosted the US dollar versus virtually every other currency. Rising US rates and the stronger dollar tightened financial conditions in most of the world, and especially in emerging markets with heavy dollar-denominated liabilities.

China’s economy, which was deleveraging to curb an unsustainable surge in credit growth, surfaced as the main target of US discontent with international trade, which also involved US allies such as Canada, Mexico, and the European Union. Investor sentiment dropped as the trade rhetoric turned into actual import tariffs and non-US markets sold off as a result. In October, US equity markets joined the downturn and led a global selloff as the buoyant US economy showed signs of weakness. What could be the next chapter for Asian equities?

In 2018, the external environment controlled the fate of Asian equities. With the US mid-term election behind, and assuming a less restrictive monetary backdrop and certain de-escalation of trade tensions, we see Asian markets gaining more control over their own destiny. In a global context, most Asian countries are ahead in structural reforms, at whatever stage they are. In India and Indonesia, reforms are about unlocking growth, focusing on labour reforms and the ease of doing business. In China, structural reforms are more about escaping the middle-income trap, which requires innovation and more value-added job creation rather than just adding jobs.

In 2019, we see China turning to domestic policies aimed at stabilizing growth and a host of reforms to retool the corporate sector, such as tax and fee-burden reliefs that will ultimately enhance profitability. India and Indonesia, two of the region’s largest economies, will hold general elections in the second quarter. This will test their resolve to remain in the reform path. In India, five states will hold State Elections in the next two months, and that should signal how things may shape up in 2019. The prevailing view is that Mr. Modi’s party retains power next year while possibly losing the absolute majority it gained in the last election in 2014. Ruling out negative surprises (i.e., Modi’s government losing the election), we believe markets will be fine, and the reaction should be proportional to the solidity of the victory.

In Indonesia, economic growth has recovered steadily since a trough in 2015, but the higher rates should downshift the current pace of just over 5%. We expect private and foreign investment to be in a wait-and-see mode ahead of the election next year. For now, foreign holdings of local bonds have come off the highs, and we see limited risk of significant foreign outflows. This trend could reverse quickly if sentiment towards emerging markets improves and investors evidence the attractive valuations of Indonesian equities and bonds against mostly positive fundamentals. Despite the likely focus on internal matters within Asia Pacific, Fed policy and its effect on the US dollar, how the rebalance of power in the US government impacts trade relations, as well as political stability in the European Union remain key external issues to monitor.

One thing we do not see changing is our flexible investment approach, which enables us to adjust portfolios based not just on valuations but economic conditions as well. At the onset of 2018, the portfolios were positioned for global reflation – rising nominal growth, wages and inflation. We still believe the global economy has room to run, and our overweight positions in the financial and industrial sectors corroborate this. However, prospects for earnings peaking amid restrictive monetary policy raises the odds of global growth moderating. This made us less bullish on certain steel and petroleum holdings that had run strongly, and decided to reallocate these assets to tech-related stocks that we liked before but did not buy due to their previously elevated valuations. From a country perspective, this reduced our relative exposure in Korea and increased it in China. In short, our portfolio management approach is very stock specific but viewed through the lens of our relative valuation and macroeconomic analyses.

Neeraj Seth, Head of Asian Credit: We believe global markets could surprise investors positively in 2019 as recent stresses wane and low valuations spur interest in risk assets. Among this year’s headwinds to Asian and emerging markets (EM), three stand out as key drivers of performance: 1) US monetary policy normalization and akin US dollar strength, 2) China’s financial deleveraging and trade tensions with the US and 3) the surge in oil prices. The strengthening US dollar set off restrictive policies in most of Asia to support financial and macroeconomic stability. As these drivers take their toll globally, we see growth slowing in 2019, including in Asia, but believe the headwinds are waning and are largely reflected in Asian asset prices. We also see policies reverting to neutral or accommodative. These dynamics underpin both, a positive outlook for the region’s risk assets and our optimism for Asian credit.

This year was challenging for the asset class, but credit metrics for Asian corporates are improving: lower net leverage, higher interest coverage and healthy liquidity. Better 12-month rolling upgrade/downgrade ratios reflect this, yet valuations have moved to historical highs on a ratings- and maturity-adjusted basis. In November 2018, Asian risk premiums reached 3-year highs (investment grade, IG) and 5-year highs (high yield, HY) relative to US credits. We see room for change in multiple fronts, including Federal Reserve (Fed) policy, trade tensions and oil’s supply /demand dynamics.

The US Republican party will need to compromise on key policy initiatives with the newly elected Democratic majority in the House of Representatives. The risk of rolling back the current tax cuts and regulatory policies is probably low, but these policies’ stimulus on US economic growth and inflation may be waning. We expect the Fed to hike rates again in December, and although we see the gradual tightening path extending into next year, the outlook is less certain. A potential Fed pause is creeping up in market valuations, which currently reflect just two more rate hikes next year. In short, we see Asian credit markets taking fewer cues from Fed policy to deliver returns in 2019.

By most estimates, trade actions should have a limited impact on economic growth, especially in China where gross domestic product (GDP) growth may reach 6.5% in 2018. China’s shift to accommodative monetary and fiscal policies helped maintain ample liquidity, offsetting drags that trade and deleveraging policies could have had on economic growth. Still, the heightened macro uncertainties sparked by US trade policies have held back returns on risk assets and marginally increased market volatility. We expect such policies’ negative effects on risk assets to decrease progressively as investors come to terms with the status quo and trade-related noise loses power. The silver lining is that any easing of US-China trade tensions is likely to boost investors’ confidence. Also, we do not expect China to retake the aggressive deleveraging of early 2018, and therefore monetary and fiscal policies should remain accommodative.

The Asia Pacific region is a net importer of oil, and this year’s surge in oil prices added stress to economies already grappling with the strengthening US dollar. This was harsher for local currency bonds of higher-yielding markets, such as India and Indonesia. However, we see oil prices beginning to shift. This year’s upswing was largely driven by supply, but the impact of Iranian sanctions is fading as Saudi Arabia, Russia and the US have increased production. This should positively impact the region’s balance of payments, inflation, local bond yields and FX volatility.

Our base case is that monetary policy moderates, the dollar stabilizes, oil prices come down based on supply-demand forces, and trade tensions turn more manageable. How do we see portfolios evolving given this backdrop?

In 2018, we positioned portfolios more defensively to address the risk factors we have discussed. We held higher-than-typical cash levels and greater diversification to minimize idiosyncratic (issue-specific) risks. We see this changing on the horizon, however. Value is emerging and this, combined with the resilient fundamentals for Asian credit, is shaping our optimism for the asset class next year.

In 2019, we expect Asian credit returns in the mid-to-high single digit range, driven largely by elevated levels of current income. We base this on current valuations and our expectation for range-bound US Treasury yields in the coming quarters. We see Asian credit continuing to grow next year, yet expect net credit supply to fall relative to its peak in 2017. This, coupled with expected inflows tied to higher return expectations in 2019, augur positives for the asset class. The key risks to our outlook include higher inflation in the US triggering a repricing of Fed hike expectations, higher oil prices and tighter monetary policy in Europe and Japan, albeit this is not our base case.

Income is the dominant driver of returns for the asset class, but the alpha sources are changing. In past years, central bank capital influxes led to lower volatility, and market beta drove the alpha streams. Investors, however, have increasingly become more discerning, and we have noticed significant dispersion across credits. This provides opportunities for active managers to generate alpha through country, sector, and security selection.

Geographically, we are positive on China and Indonesia but are, in the near term, cautious on India. In China, we still like higher quality IG credit and HY real estate credit. Falling supply of Chinese A-rated quasi-sovereign credit is a tailwind for the sector, but we expect differentiation among BBB-rated credits of state-owned enterprises where security selection is key. Elsewhere, we expect support from stable fundamentals and the increased ability for large-cap HY real estate issuers to refinance onshore. Fundamentals of HY industrials are mixed, but we see attractive opportunities for security selection. We are cautious on India on the back of election uncertainty and the risk of fiscal slippage. Finally, in Indonesia, we see opportunities due to expectations of a stable dollar (and rupiah) and policy continuity as the President’s increasing popularity and a lack of viable opposition candidates reduces election uncertainty.

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