Asian equities continued their outperformance of other global markets in September, extending a remarkable recovery from the shortest bear market on record. This reflects an equally impressive rebound in economic activity, but most countries are still operating below full capacity and the initial snap-back is likely over. Is now the time to reduce risk in portfolios?
There’s certainly no need to panic. Fidelity’s proprietary GEARs (Gauges of Economic Activity in Real Time) indicator for Asia’s largest economies continues to rebound strongly. The China GEAR has been in positive double digits for a third consecutive month, implying that GDP is comfortably above its pre-health crisis peak.
But some recent economic data are pointing to slower gains ahead for the region.
Take, for example, Korean exports — an important barometer for global demand. The first 20 days of August indicated a slowing of momentum, but the divergence in destinations was perhaps more interesting. It showed exports to the US picking up, fewer to Europe and Japan, and flatlining exports to China.
A slowdown in the pace of economic recovery is likely to cap further improvement in earnings estimates for the year ahead. The net percentage of upward and downward revisions in earnings forecasts, which is usually a good guide to short-term equity returns, is now not far from positive territory — a level at which it has rolled over in recent years.
This suggests some caution is warranted, and is perhaps why investors continue to pay a premium for the prospect of resilient earnings growth among tech stocks. A quality growth-style bias and tilt to China and Northeast Asian equities continues to make sense. And there is still value to be found. For example, while average valuations for offshore China equities lay at the top of their historical range, A-shares still trade at an appealing discount to them.
The most recent earnings season also showed better earnings for onshore stocks. This has helped A-shares weather rising political tensions between the US and China. Increasing investment in Asian high-yield bonds also helps to reduce portfolio risk while maintaining some upside return potential.
Despite a stunningly quick double-digit gain from high-yield bonds since credit spreads peaked in March, valuations still offer adequate compensation for credit risk.
The default rate should peak at around 6% in a reasonable base case, which compares favourably with other developed-economy high-yield markets. The key is that onshore funding conditions remain supportive.
A useful indicator is the net issuance of double- A-rated onshore bonds, which tracks well with the default rate in the offshore high-yield market. Liquidity conditions have improved, and onshore funding costs have fallen as China progresses its fiscal and monetary easing. Issuing bonds onshore is still some 400 to 500 basis points cheaper than the offshore market for sub-investment grade rated property issuers, for example.
As a result, onshore issuance has been strong, suggesting defaults in the offshore China high-yield bonds should be limited. Meanwhile, credit spreads are still around 175 basis points wider than their 10-year average. There remains potential for another double-digit return if they narrow to that average.
We think this is conceivable given that the economic recovery in China is stronger than elsewhere, while high-yield bonds should come with less downside risk than equities in an adverse economic environment.
So, while the swift recovery and continuing rise in stock markets over the last few weeks have made some investors turn cautious — and rightfully so — we think it is too early to turn fully defensive. Attractive pockets of opportunity remain — and we will be keeping a close watch on how economic and corporate fundamentals evolve with virus, policy, trade and US election developments.
George Efstathopoulos is portfolio manager at Fidelity International
