Over the past two decades, a cottage industry of sorts has emerged within the global intelligentsia predicting the rise of an “Asian century”. For thinkers like Kishore Mahbubani and Parag Khanna, the rapid growth of Asia’s emerging markets (EMs) would turbo-charge these once poverty-stricken ex-colonies to wealth and prominence. Last year, the World Economic Forum said that Asia would have the world’s largest GDP by 2020, exceeding that of the rest of the world combined.
But as Covid-19 ravages the global economy, EM Asia can now add “resilience” to that long list. EM Asia economic recovery is set to outpace that of EM Eastern Europe and EM Latin America. Sean Taylor, DWS’s Asia Pacific chief investment officer, predicts 7.4% growth in 2021 vis-a-vis 3.7% for each of the latter. While EM Asia will likely see its first recession in six decades with a 0.7% contraction this year, the Asian Development Bank sees growth returning to 6.8% in 2021.
Prospects of a quick recovery by the end of this year remains strong. A sharp reduction in US unemployment also hints at US economic recovery, which will benefit export-oriented EM Asia despite fears of a Covid-19 resurgence. “Particularly relevant for Asia is what has been happening with world trade. Although clearly [global trade] has faced a sharp drop in the first and second quarter, again we are seeing that recovery albeit from low levels,” says Simon Weston, senior portfolio manager, Asian equity at AXA Investment Managers (AXA IM).
Unlike EMs in other parts of the world, EM Asia enjoys stronger economic fundamentals before the pandemic hits, which provides cushion on the way down, and also the leg up when recovery happens. “Asian countries and companies went into this downturn in relatively sound shape: state fiscal balances are relatively healthy, Asian companies have comparatively defensive balance sheets, and Asia has seen no large build-up of excess capacity,” says UBS head of EMs and Asia Pacific equities Geoffrey Wong and head of fixed income Hayden Briscoe. They expect the long-term impact of Covid-19 on EM Asia to be small.
EM Asia economies are also seen to be at low risks of suffering from unfavourable foreign exchange movements, says Ian Samson, assistant portfolio manager at Fidelity International, referring to the US dollar which is coming to the end of a 10- year cycle of over-valuation.
Where the greenback was once a safe haven for investors due to high US interest rates following strong economic performance, it is now less compelling for investors due to Fed rate cuts. Consequently, there may be strong capital movement into EM Asia currencies — with the RMB likely to be a regional anchor — reducing the foreign exchange risks of investing in EM Asia assets.
However, this opportunity occurs against the backdrop of significant political risks, says Stuart Ritson, portfolio manager for EM local currency debt at Aviva Investors. US President Donald Trump, for one, has hinted that he would contest the outcome of the upcoming presidential elections if he loses. Given that the US dollar tends to rise during periods of rising volatility, he argues, there might be spillover volatility inflicted on Asian currencies. A second Trump administration could also add to geopolitical risks and continued trade unilateralism, catching export-oriented EM Asia in the crossfire.
The China factor
Much of EM Asia’s growth has been driven by robust economic performance in China, which is seen to bounce back from its 1Q lockdown and end with a 2% full year growth for 2020 and is expected by DWS’s Taylor to accelerate to 8.5% growth in 2021.
Despite four local mini outbreaks of Covid-19, senior emerging Asia economist at AXA IM Aidan Yao sees China experiencing a rapid V-shaped recovery. He anticipates that the world’s second-largest economy will return to its projected growth trajectory by end2020 — 3Q2020 and 4Q2020 growth accelerating to 5% and 6% respectively.
China’s economy contracted by an unprecedented 6.8% y-o-y in 1Q2020, but rebounded by 3.2% y-o-y in 2Q2020. However, the recovery has been uneven. Industrial production of medical equipment and electronics enjoyed strong growth from both local and overseas demand. Fixed asset investment recovery, meanwhile, has been more gradual while retail sales — which has lagged behind other sectors — reflects a much weaker L-shape recovery for household consumption.
“We have seen some fine-tuning of China’s monetary policy. There has not been major policy easing such as interest rate or required reserve ratio (RRR) cuts since the end of 2Q2020, and the People’s Bank of China (PBOC) has also become somewhat more reserved with liquidity injections,” Yao told an AXA IM media briefing. He expects Beijing to continue its planned fiscal stimulus to sustain the momentum of infrastructure investment. Similar to DWS’s Taylor, AXA expects China’s full-year growth to reach similar levels of 2.3% in 2020 and 8% in 2021.
Despite concerns about de-globalisation, Yao says that China has been coping well with a less open world since the Global Financial Crisis. While it lost 2% of US import market share between 2017 and 2019, China’s exports continued to make steady gains in global market share. Its share of global manufacturing value-add and world trade continues to follow a steady upward trajectory to around 30% and 25% respectively despite worries of supply chain rerouting arising from the US-China trade and technology war.
Still, Yao sees low-cost manufacturing businesses as most likely to reroute supply chains out of China due to rising production costs, coupled with the onset of trade tariffs. Businesses serving China’s massive consumer market like McDonald’s and Tesla, however, are likely to stay as the country eclipses the US as the world’s largest retail consumer market. But it remains to be seen if firms relying on China’s efficient supply chain networks (like medical equipment and electronics, for example) will stay or go, as they come under regulatory and political pressures to diversify their supply chains.
Nevertheless, Yao sees Beijing’s commitment to structural reforms, such as financial liberalisation, making China ever more indispensable to global and regional supply chains. This will result in a “China Plus One” model, where businesses will use other Asian EMs as backups to China. As such, China will not only remain pivotal to global supply chains, but will also accelerate the regionalisation of Asia as its growth is diffused throughout the region.
Hedge your bets
No thanks to the US Fed’s policies, interest rates have been pushed down to near zero, affecting bond yields. Investors, hungry for better returns, have been known to be caught between weak gains and risky investments.
In this backdrop, EM Asia bonds provide investors the best of both worlds: investment grade bonds with better yields. Around 80% of the Asian US dollar bond market comprises investment grade bonds, offering 2.53% yield over 5.25 years compared to 2.07% over 8.26 years for US investment grade bonds.
“Asian investment grade bonds have outperformed other global fixed income segments in terms of risk-adjusted returns (five-year rolling), with a Sharpe ratio of 1.02, as opposed to US investment grade bonds at 0.78 and emerging markets at 0.43,” says Arthur Lau, head of Asia ex Japan fixed income for PineBridge Investments Hong Kong. It is for this reason, adds Ritson, that Aviva’s investing strategy for the coming months is to overweight on low yield, high quality assets in Asia to hedge against future uncertainty.
But Elisabeth Collaran, EM portfolio manager and credit strategist at Loomis Sayles, also sees high-yield assets and corporate assets as being attractive internationally. Not only are Asian high-yield bonds trading at 7% yields vis-a-vis US high-yield (5.7%) and EU high-yield (3.9%), their stronger corporate fundamentals makes them safer too. Thu Ha Chow, portfolio manager at Loomis Sayles, notes that Asian high-yield default risks are expected to stand at around 4% for the rest of the year, with US high-yield default rates seen to be about double that.
Better yet, current sector valuations for EM Asia bonds look attractive vis-a-vis the past five years. Jim Veneau, head of fixed income Asia at AXA IM, sees high-yield valuations looking relatively attractive as bond spreads tighten to around historical levels. DWS’s Taylor echoes this sentiment, seeing relatively attractive long-term value in EM Asia fixed income despite Veneau observing that investment grade assets are gradually approaching fair value.
Taylor suggests that investors load up on China government bonds and other selected government bonds in EM Asia for strong yields and cash protections. He also urges investors to buy into some high-quality investment grade assets from Asia as well; these tend to be less volatile than buying international bonds since these are mainly bought by Asian investors. Fidelity’s Samson also sees Chinese government bonds as useful cyclical hedges against a Chinese slowdown.
Aviva’s Ritson, meanwhile, believes that Indian government bonds that are at the front-end of the yield curve look promising, as they are backed by central bank policies and inflationary pressures that will likely subside going forward. The rupee should remain well-underpinned, he says, given India’s current account surplus and robust capital flows. But Samson urges caution, arguing that limited structural reforms, large government deficits and stubborn inflation could hinder Indian economic stimulus.
Betting on growth In the equity space, investors have to contend with a bifurcated market where much of the gains have been concentrated within just a few high growth sectors. Weston observes that the weight of the top five stocks on the MSCI Asia Pacific ex-Japan index has risen dramatically to an all-time high of 24%, suggesting a rather concentrated recovery. Beneficiaries from this growth tend to be e-commerce and technology names such as Alibaba Group and Tencent in China, as well as Taiwan Semiconductor Manufacturing Company, which have benefited from lockdown measures brought upon by the pandemic.
This trend has further underscored how growth stocks, led by the big tech names, have outpaced value plays on the MSCI APxJ since the Global Financial Crisis. “This divergence in many cases has been almost unprecedented in its behaviour,” says AXA IM’s Weston, noting that investors’ willingness to place a premium on future growth is likely to persist for some time.
With MSCI APxJ at around 17.2 P/E ratio, Weston sees EM Asia equities as rather attractively-valued, relative to that of developed markets. But Taylor of DWS warns that from a historical perspective, at this level, EM Asia stocks are starting to look less attractive relative to their historical P/E ratio. Markets have also priced in the recent global market rally, with a Bank of America Merrill Lynch survey of fund managers positioning for a strong recovery, thereby making it relatively more difficult to find bargain buys.
Yet Taylor points out that the relatively low P/B multiples of EM assets still make them reasonably attractive, especially relative to the strong economic growth recovery. “We believe that any pull back should be viewed as an opportunity to buy,” he says, remarking that a P/B ratio below 1.5 in Asia would interest most investors. In any case, he tells The Edge Singapore, valuations in EM Asia tend to be secondary to a compelling growth story being more important in this rapidly growing region.
Taylor urges investors to buy into the digital transformation of Asia. Valuations at current levels might seem rich, but there is also the longterm prospect. Not only are these stocks cheaper than their US counterparts, they are also more insulated from regulatory risks should Joe Biden win the US Presidential elections, adds Taylor. He also recommends buying cyclical stocks in anticipation of a vaccine emerging in 2021, where considerable market liquidity is likely to kickstart a significant market upswing as economies re-open.
While there has been some capital outflow from EM assets, the increasing participation of local investors has helped pick up the slack. Local investors in South Korea, Taylor observes, are buying up twice as much equities as that sold by foreign investors year to date. With yields so low across the world and EM Asia assets relatively safer nowadays, local investors are more comfortable investing at home. Maybe it is time for global investors to follow the money to Asia.
