CPD: Asian equities – from headwinds to tailwinds

As developed markets – notably the US – achieve new highs, Asian equities have been out of favour with investors. However, headwinds that have muted growth across Asia (ex-Japan)^[1] are changing direction and many in the market expect, tailwinds will fan a resurgence in earnings and share price growth in the sector.

Growth in developing regions of Asia accelerated in the first quarter of 2024 because of resilient domestic demand and strong export growth, particularly in electronics. The GDP forecast for the broader region in 2024 has increased to five percent and is projected to be 4.9 percent in 2025 ^[2]. From a purely opportunistic perspective, Asian equities are ‘cheap’ by virtue of being out of favour for a prolonged period of time. The geographical spread of valuations remains significant and, in many cases, elevated (figure one). Asia is trading cheaply relative to its history and other regions, notably the US.

Source: Bloomberg and Man Group as of 8 August 2024. The organisations and/or financial instruments mentioned are for reference purposes only. The content of this material should not be construed as a recommendation for their purchase or sale. 12-month forward P/E based on next four quarters of Bloomberg consensus earnings estimates.

However, the valuation discount has been in place for many months – what makes now a turning point?

Global alternative investment manager Man Group sees three key reasons that investing in Asia is at a turning point:

1. Interest rates
2. China
3. Technology

Each of these will now be explored in more detail.

1. Interest rates

With forecast inflation at three percent^[3] for 2025, Asian central bank policymakers are in a position to cut interest rates. However, they are unlikely to move before the US Federal Reserve (Fed) pivots from rate hikes to rate cuts. Monetary authorities across Asia have delayed policy rate cuts to keep their local currencies competitive against the US dollar.

Over the past six months, inflation across both mainstream and developing Asia has generally stayed within the target ranges set by Asian central banks, leading to a decline in inflation that aligns with their goals. Under normal circumstances, this would have prompted these central banks to cut interest rates, but they have refrained from doing so due to concerns about currency depreciation.

With a strong US dollar and high US interest rates, rate cuts in Asian countries would weaken their currencies further, increasing the risk of importing inflation. Southeast Asian countries have historically been sensitive to this issue, and this time, even China had to follow suit, resulting in real interest rates in China that are higher than the economy can sustain.

China’s GDP has fallen short of expectations, and while the economy should ideally be in an easing cycle, the focus on protecting the currency has prevented this. However, following the moves on 31 July and more recently, there has been a noticeable strengthening of Asian currencies, which could give central banks the confidence to begin cutting rates. This anticipated rate-cutting is likely to lead to a positive re-rating of equity markets, signalling a favourable outlook moving forward. Over the next few months, we can expect a robust easing cycle across many Asian countries; with India being a notable exception due to its strong growth, which likely negates the need for rate adjustments. In contrast, China and Southeast Asia are expected to see some monetary policy shifts, marking the first step of support for these economies.

So, once the Fed starts to reduce its policy rate, the regional inflation backdrop provides the scope for Asian central banks to commence their own cutting cycles, which in turn provides a tailwind to asset prices.

Using Indonesia as an example, figure two illustrates that historically, when real yields decrease (as indicated by the rising yellow line due to its inverse plotting), Indonesian equities tend to outperform the global market (indicated by a rising blue line). Conversely, when real yields increase (yellow line decreases), Indonesian equities tend to underperform the global market.

This pattern suggests that Indonesian equities tend to perform well relative to global equities during periods of falling real yields. This is generally due to easing monetary conditions, which tend to make equities more attractive and boost economic activity, leading to better performance of local share markets. When the Fed eases its policy, resulting in lower global yields, the environment historically benefits Indonesian equities relative to the world. This scenario is equally applicable to other markets in developing Asia.

2. China

The Chinese economy is at the end of an economic model reliant on investment and credit, necessitating a shift to a new approach. In the short term, the current economic weakness can be attributed to China’s tight monetary policy, which is relatively restrictive given the state of the economy. Despite low nominal interest rates, China is experiencing high real interest rates due to deflation, which forces people to save more and consume less – a counterintuitive approach during a period of deflation and weakening growth.

However, the reason for maintaining high interest rates is currency stability. China has learned from the 2015-16 deflation scare, where early rate cuts led to capital outflows, downward pressure on the currency and financial instability. In this cycle, China has deliberately pegged real interest rates to a level that aligns with US rates to preserve currency stability. While China has historically run an independent monetary policy, it is now closely aligning its policy with that of the US to protect its currency, resulting in a tight monetary stance. As the Fed enters an easing cycle, Chinese rates will likely ease, which will support increased consumption. Currency devaluation of the RMB could also be very supportive for equities.

In June 2024, China held its third plenum, a five-yearly top-level meeting which delivers important signals of Beijing’s economic strategies and makes policy decisions for the coming five years. The plenum was swiftly followed by a politburo meeting, at which top government officials take the strategic views developed at the plenum and determine how to implement them.

The key takeaway from the third plenum and subsequent meetings is that China will do more to address the debt-deflation cycle it emerged from after the pandemic. There are some exciting developments coming out of China. Unlike in recent years, where we’ve seen large-scale stimulus packages, China is currently focusing on more targeted fiscal easing, particularly empowering local governments rather than relying on central government intervention.

In addition to fiscal reform, there’s also a concerted effort to reduce the high savings rates among Chinese households (figure three). Traditionally, Chinese households save a lot because they must, given the lack of a robust social safety net or social security. Over the past decade, there has been a significant migration from rural to urban China, which has been a key driver of Chinese growth.

However, when workers move to cities, they are required to pay into the social security system of that city but are not granted access to the social welfare benefits, such as healthcare, education or housing. As a result, many workers save their earnings and send them back to their rural villages, choosing not to bring their families to the cities due to the lack of support. This situation has created a scenario where workers are essentially double-paying – supporting themselves in the city while also sustaining their families in the villages. The core issue is that any existing safety nets don’t extend to where these migrants currently live.

We can expect significant changes with the implementation of hukou reforms, China’s household registration system. These reforms aim to grant migrants the same rights as local residents in cities, including access to social insurance, housing support and education. This would be a major development, allowing families to settle more confidently in urban areas and should unleash precautionary household savings.

Additionally, once these families are provided with a safety net in the cities, they may feel secure enough to monetise the rural land they previously held onto. This creates a twofold positive impact: lower savings rates leading to increased consumption and the ability to monetise rural land. Both of which could greatly benefit China’s economy.

Cumulatively, this change is likely to make a significant difference to the domestic consumption story, which will be more focused on services than goods. In the same way the western world today likes to eat well, travel often and stay in nice hotels, Chinese consumption is expected to change focus from a goods to service economy.

3. Technology

The third key aspect likely to benefit Asia is technology. Here the major focus is on the current tech cycle and its winners. So far, the biggest beneficiaries have been the enablers, such as chip makers which have reaped significant rewards from the rise of Artificial Intelligence (AI).

However, as the cycle progresses the next wave of beneficiaries is emerging, particularly those leveraging large language models which are now commercialising AI technology.

Looking ahead, Asia stands to benefit disproportionately from the upcoming infrastructure and devices cycle due to its significant exposure to hardware manufacturers. In recent years, there hasn’t been a compelling reason to upgrade hardware such as phones, laptops or tablets, as there was no substantial benefit. However, with the anticipated introduction of AI-enabled devices in the second half of 2024, a new catalyst is emerging that could reignite investment in tech hardware. Companies in Taiwan, South Korea and China are well-positioned to benefit from this development, marking the third stage of the AI cycle, which is likely to favour Asia more than any other region.

The tight financial conditions that have been imposed on Asian markets, primarily due to global rather than domestic factors, have weighed heavily on their economies and stock markets in recent times. Even in relatively resilient economies, the fear of prolonged tight monetary policy has dampened investor sentiment, driving down valuations and creating concerns about long-term growth.

However, there is now a strong case for optimism. As we anticipate a shift toward looser monetary policies and rate cuts, these markets are poised for a significant rebound. Smaller economies such as Indonesia and the Philippines, which have seen solid corporate earnings growth despite the challenges, are particularly well-positioned to benefit.

As developed markets begin to pivot away from peak monetary tightening, these economies are likely to experience improved earnings growth and higher valuations. The recent appreciation of local currencies, especially in Indonesia, signals the start of this positive trend. With a weaker dollar and potential Fed rate cuts on the horizon, the future looks bright for Asian equities, making them an attractive investment opportunity as global financial conditions become more favourable.

Equity Risk: The value of equities and equity-related securities can be affected by daily stock movements. Other influential factors include political, economic news and company earnings. The information included in this article is provided for informational purposes only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of Man Group and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Man Group, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

 

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Notes:
[1] References to Asia and Asian equities in this article refer to Asia ex-Japan, unless otherwise noted
[2] Asian Development Bank, Economic Forecast July 2024
[3] Ibid.