SINGAPORE (July 17): Chinese equities, which have outperformed the US and European markets year to date, remains favoured by UBS Asset Management, with some showing clear signs that China’s economy is recovering from the Covid–19 lockdowns. Coupled with the strong capacity to stimulate the support of the economy, investors can also take comfort that they can stay vested in China, the world’s second-largest economy.
“The Covid–19 crisis has been a very good test of the standalone China thesis,” says Geoffrey Wong, head of emerging markets and Asia– Pacific equities at UBS Asset Management (UBS–AM). “Though not yet back to pre–Covid–19 levels, industrial activity has recovered to a large degree,” he adds.
China was the first to report the outbreak but it was also quick to impose strict lockdown measures that helped curb further spread. It is now showing signs it is back in business, with indicators such as intra–city traffic and coal consumption recovering, showing that factories are back at work. On the other hand, countries like the US are grappling with worrisome spikes in second wave numbers. While US markets have largely recovered from the big drop in late March, there are now growing concerns that US equities have run too far ahead of the actual recovery of the economy in the US. As such, savvy investors might want to look elsewhere. China might just be an alternative, and one which is relatively insulated from what is happening in other markets.
“China’s equity market remains under-represented in global equity indices. Also, the correlation between domestic China and other equity markets remains low and this was again proven during this crisis,” reasons Wong.
Apart from China, UBS–AM sees a similar pattern with South Korea. “China and Korea, which suffered from virus outbreaks before their emerging market (EM) counterparts, could outperform that cohort due to their status as the first to stabilise activity and implement strong contact tracing infrastructure,” it notes.
Demographic and structural trends
Still, UBS–AM is not just optimistic about China and South Korea. Beyond the economic fallout from Covid–19, the asset manager is also upbeat that EMs — as a whole — will do well, thanks mainly to favourable demographic trends as well as structural shifts. Wong also notes that the pandemic has sped up structural trends such as digitalisation, particularly in the business segments of after– school tutoring, financial services and telemedicine.
However, the disruption has not changed long–term fundamental drivers such as demographic trends, which will help lift domestic consumption in a sustainable manner. The population of working–age people in EMs is seen to grow 0.81%, on average, per year between 2020 and 2050. In contrast, the working-age population in developed markets will dip by 0.3% per year. “The world’s new working population and consumer bases will come from EM and support domestic demand growth,” says Wong.
The way consumers spend in EMs has also shifted towards discretionary purchases and less on staples — a sure sign of growing affluence. Such a phenomenon has already been observed even before the Covid–19 outbreak. For example, despite total car sales in China falling 5.9% y–o–y in 2018, German luxury brands BMW and Mercedes Benz saw a 7.7% and 11.1% increase in sales respectively.
The appetite for luxury items also extends into the domestic demand for baijiu, the Chinese–style white liquor, of which the most famous is the Maotai brand made by the state–controlled company Kweichow Moutai. While compound annual growth rate (CAGR) for low–priced baijiu is expected to fall 1.7% between 2018 and 2023. Brands in the premium, super–premium and ultra–premium segments, in contrast, will see growth of 9.5%, 14.1% and 16.7% respectively in the same period. “As incomes rise in EM, consumers are shifting their wallet share towards discretionary consumption and better–quality goods and services,” explains Wong.
Better buttressed EM
EMs have suffered their fair share of past crises, such as the 1997–1998 Asian Financial Crisis and the Wall Street–led Global Financial Crisis of 2008–2009. While the Covid–19 crisis is affecting more economies than before, UBS–AM is upbeat that emerging markets are able to weather the crisis in relatively good shape.
For one, governments and central banks of EMs are better positioned to mount support and rescue. Asian central banks have more room than those in the US and Europe to deliver rate cuts over the next 12 to 18 months, says Hayden Briscoe, head of fixed income for UBS Asia-Pacific.
They have also shown a willingness to act quickly. In April alone, central banks in 11 EM countries cut rates — namely, China, India, South Africa, Russia, Mexico, Poland, Turkey, Philippines, Peru, Colombia and Pakistan. “This has been possible because most countries in the EM space have maintained a prudent policy mix so far with respect to their real rates, and had room to cut rates,” says Wong.
Additionally, EM companies have more defensive balance sheets than those in the US and Europe, a gradual improvement since the 1997−1998 Asian Financial Crisis. “That said, we may see a temporary increase in leverage in the coming months as EM companies work through the crisis period.” In addition, Wong also notes that Asia entered the outbreak with no large build-up of excess capacity, owing to low investment and capex in the past decade. “Hence, capacity should get filled relatively quickly once [the] situation normalises.”
EMs are relatively less reliant on export-driven growth, as they have generally boosted their domestic economies. “Over the years, the composition of EM has shifted towards domestic sectors like consumption, e–commerce and financial services, and away from more global sectors like energy and materials, thus making EM less exposed to a global downturn,” says Wong.
For example, retailing as an industry sector comprises a weightage of 9.3% in the breakdown by MSCI industry groups for 2019, versus 0.9% back in 2008, when the last big economic crisis hit. Similarly, media and entertainment as an industry comprises 7% in 2019, versus just 1% back in 2008. In contrast, the weightage of energy has dropped from 24.8% to 7.4% in the same period.
Finally, current EM valuations offer attractive entry points for longterm investments. In Asian fixed income markets, credit spreads are at their widest since the GFC, says Briscoe. “At current levels, credit spreads can deliver substantial yields into investor portfolios. Investors should also bear in mind that periods of major market dislocations and drawdowns, like the GFC, are often followed by large returns for investors.”
“Looking over the past twenty years, EM equities have tended to recover quickly after key outflow periods such as the SARS outbreak in 2002, and the Global Financial Crisis of 2008–2009,” says Wong. “So while it is difficult to predict the possibility and shape of a second Covid–19 wave, we are focused on companies that can withstand at least 12 months of very difficult conditions in terms of balance sheet and cash flows.”
The two–year–long trade war between US and China prior to the outbreak of Covid–19 had forced many companies to reshape their supply chains. They are being forced to incur additional costs as they build up new networks of suppliers outside China. Yet, by doing so, they have set the stage for parallel growth to take place, thereby giving investors additional spots to place bets on. Southeast Asia and India, for example, are potential beneficiaries of this “China plus one” strategy, says Wong.
