Lower inflation, Chinese re-opening and macro stability. Are Asian EM equities poised for a comeback?
Lower inflation, Chinese re-opening and macro stability. Are Asian EM equities poised for a comeback?
October 2022
Dull moments rarely seem to occur for portfolio managers. If a housing crisis is not playing havoc in your largest market, you can be certain that a pandemic, global inflation crisis or another such pleasant event is right around the corner.
We may have reached a point of stabilisation, where growth leads to mean reversion in earnings and the macro picture brightens considerably.
But notwithstanding the challenges of the past few years, now more than ever may be a good time to be exposed to Asian emerging market (‘EM’) equities. Indeed, the factors that have caused such turbulence may now be played out: China, the largest market in our universe, may well be about to re-open, boding well for regional growth. Likewise, higher interest rates, lower inflation and surplus labour may make the region the best candidate to shake off a global recession. And most importantly, positive earnings revisions (in our view the key driver of equity prices and therefore alpha) are well below long-term averages, and are starting to trend up. It is certainly too early to say that Asian EM equities are trouble free. But we may have reached a point of stabilisation, where growth leads to mean reversion in earnings and the macro picture brightens considerably. Could EM Asian equities be ready for a comeback?
Vaccines, Renewed Chinese Stability and Inflation Resilience
The biggest influence on Asian EM equity returns at an index level is the direction of the Chinese economy. This has caused some volatility over the past 18 months: as we have written earlier in the year, China has faced a perfect storm, with a real estate crisis and tech selloff compounding the macro damage of the pandemic. However, we would argue that the Chinese economy has now reached a place of greater stability.
China’s greatest economic challenge has been the policy consequences in containing the Covid-19 pandemic. Lockdowns have been reimposed across the country in 2022, damaging the economy and dampening the recovery. However, hope may be on the horizon. Early testing for Chinese mRNA vaccines have gone well, and two oral antiviral pills have been approved.1,2 With higher levels of immunity potentially around the corner, we may see policymakers able to avoid lockdowns in the future, restoring the region’s major economy to full health.
In addition, monetary policy runs counter to the global trend, with the Chinese one-year prime loan rate falling 5 bps3 and the 5-year prime rate falling 15bps (Figure 1). Having tightened much earlier in the cycle than other major economies, Chinese policymakers are now looking to restart growth rather than curb runaway inflation. The Chinese credit impulse continues to trend up, and liquidity continues to be made available to troubled sectors, particular in property where policymakers are using credit to fill the gap in demand (Figure 2). Policy support now provides a tailwind to equities rather than the headwinds we have had to become used to in the past two years.
Figure 1. Chinese Prime Loan rate – 1-Year and 5-Year
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Source: Bloomberg; as of 29 September 2022.
Figure 2. China Credit Impulse
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Source: Bloomberg; as of 29 September 2022.
Looking at the region more broadly, it is worth considering how wider trends affect EM Asian equities. As exporting economies who tend to import raw materials and export finished goods, inflation can be either blessing or curse for Asian countries. In a demand-pull scenario, inflation is a positive factor – there’s a greater aggregate demand than limited supply can keep up with. But if the inflation is cost-push, the effects of higher wages and raw materials cost reduces the supply of goods available.
As such, three of the big drivers of cost push inflation – energy, food prices and shelter – are likely to be either slower or lower in Asia than in their DM counterparts. We are already seeing this dynamic borne out, with Asian inflation running lower than that in major economies such as the US, UK, Germany, France and Japan.
Global inflation has been driven by a number of factors – supply chain disruption, higher than expected demand for durable goods during the pandemic, a speedy rise in aggregate demand during its aftermath (abetted by exceptionally loose monetary and fiscal policy) and the disruption of energy and commodity markets since the invasion of Ukraine. This current part of the inflationary phase is therefore cost-push rather than demand-pull, which has in turn put pressure on Asian EM economies, especially those such as China which are net energy importers. Indeed, Chinese crude oil, natural gas and coal imports totalled CNY2253 billion in 2021, and were the second, fifth and ninth largest category of goods respectively. Forecasting the direction of energy prices is a challenge: while oil prices are down around 20% from their 2022 highs, natural gas prices continue to rise, particularly in Europe (Figure 3-5). Nevertheless, although the geopolitical situation may continue to prop up energy prices, we may have reached a plateau when it comes to other elements of the inflationary basket. As grain shipments from Ukraine restart, global food prices continue to moderate, and aside from China, most EM Asian economies do not have quite the same housing cost pressures as in DM economies. As such, three of the big drivers of cost push inflation – energy, food prices and shelter – are likely to be either slower or lower in Asia than in their DM counterparts. We are already seeing this dynamic borne out, with Asian inflation running lower than that in major economies such as the US, UK, Germany, France and Japan (Figure 6). It is also worth commenting that while inflation in DM is rolling over, the supply chain situation remains exceptionally precarious, especially in energy commodities, as evidenced by the leaks in the Nordstream 2 gas pipeline.4
Just as inflation in Asian EM economies is lower, interest rates are also higher (Figure 7). This combination gives much greater leeway to central banks as they seek to support demand through a possible global recession. Whilst DM central banks dare not ease monetary policy, for fear of driving high inflation still higher, Asian central bankers have the room to cut rates if they feel necessary. In relative terms, the region enters a period of falling growth in a position of greater strength than its competitors, with more policy levers to pull should the situation deteriorate. Overall, while Asian economies remain vulnerable, they may be less vulnerable than their DM counterparts.
Figure 3. Major China Goods Imports (USD)
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Source: BACI HS6 REV, Comtrade; as of 31 December 2020.
Figure 4. Generic 1st Crude Oil Prices – Brent Versus WTI
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Source: Bloomberg; as of 29 September 2022.
Figure 5. European Natural Gas Prices – EUR per KwHv
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Source: Bloomberg; as of 30 August 2022.
Figure 6. Headline CPI – Asia ex Japan Versus US
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Source: Bloomberg; as of 29 September 2022.
Figure 7. US Versus Asian Policy Rates
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Source: Bloomberg; as of 29 September 2022.
The US Dollar Cycle and Labour Shortages
In response to rising US inflation, the Federal Reserve has enacted one of the steeper hiking cycles amongst DM central banks, leading to a growing interest rate differential compared to other DM currencies. With a larger rate differential, a carry trade becomes more attractive, and in response the dollar has strengthened significantly. Asian earnings have historically had a strong negative correlation to the strength of the US dollar (Figure 8). As such, recent dollar strength could have been something of a headwind for Asian equities. Furthermore, with US unemployment still low, the Fed remains firmly committed to its course of higher rates to combat rising inflation.
However, the correlation between dollar strength and Asian equity weakness has not re-asserted itself.
However, the correlation between dollar strength and Asian equity weakness has not re-asserted itself. In our view, this is in part driven by the lack of speculative excess in south-east Asian assets. Whilst Western DM equity markets rallied strongly in the wake of the Covid-19 pandemic, the slower exit from lockdown across much of Asia muted post-pandemic earnings and were consequently less euphoric in comparison. Although a strong dollar would traditionally force speculators in the region to confront reality, with minimal speculative excess, the hard rain of a rising dollar has had little euphoria to flush out.
Figure 8a. Historical Outperformance of Asian Equities on Dollar Weakness
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Figure 8b. Relative 2022 Outperformance on Current Dollar Strength
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Source: Bloomberg, Man GLG; as of September 2022.
Irrespective of the direction of global inflation or the US dollar, DM economies are suffering from a significant labour shortage. US job openings have consistently outnumbered US job seekers since December 2020, an unprecedented situation (Figure 9). Likewise, major European economies such as the UK have seen a significant reduction in the workforce after the end of furlough.
If DM countries cannot recruit locally, we expect more operations to be offshored; a process which is likely to benefit EM Asian economies more than most.
If DM countries cannot recruit locally, we expect more operations to be offshored; a process which is likely to benefit EM Asian economies more than most, many of which have a labour surplus and no shortage of qualified workers. Indeed, while the value of global outsourcing has doubled since 2000 (Figure 10), the unique shortage of DM workers may mark a secular shift and accelerate the trend as never before. Furthermore, there is an uneven distribution of these offshoring roles. With geopolitical tensions running high, we expect more unaligned southeast Asian economies to benefit. Likewise, tensions may see a stronger incentive for Chinese firms to onshore their own production and supply chains. Both tendencies benefit the regional economy as a whole, and are likely to support household earnings, with the consequent boost to demand across the region.
Figure 9: US Unemployment Versus Job Openings
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Source: Bloomberg; as of 29 September 2022.
Figure 10: Global Market Size of Outsourced Services
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Source: TPI; Information Services Group; as of 31 December 2019.
Indeed, on a 3-month rolling basis, the recovery has already begun.
Mean Reversion: Earnings
The past year has put enormous pressure on EM corporate earnings, evidenced by the change in revisions ratios. The ratio of upwards revisions to down has fallen to around 35%, below its long-term average of 45%. In our view, this headwind will likely abate as the macro environment stabilises. Indeed, on a 3-month rolling basis, the recovery has already begun (Figure 11). As we can see, earnings revisions are the key determinant of future multiple expansion, and, in our view, are the single most important factor dictating equity returns. As such, if we see mean reversion in revisions, it should bolster Asian equity performance over the near term. If the biggest driver of equity returns moves in our favour, we therefore feel it may be possible to revise our previous caution.
Figure 11: Asia ex Japan 3-Month Earnings Revision Ratio Signal (YoY) Versus 12-Month Forward PE
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Source: Bloomberg, Man GLG; as of September 2022.
While we are positive on the overall direction of the index, such different returns may create a prime opportunity for active managers with conviction to outperform.
Having previously had a negative outlook towards beta, we are now much more optimistic on the general trend of the index. Nevertheless, even in an upswing, there will be outperformers towards which active managers should lean. Driven by Chinese re-opening, and better relative outlook for growth than in DM, we see these opportunities as being primarily in healthcare, consumer discretionary, certain industrial companies and travel. We also note the large dispersion in earnings revisions by country (Figure 12). While we are positive on the overall direction of the index, such different returns may create a prime opportunity for active managers with conviction to outperform.
Figure 12: Earnings Revisions by Country
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Source: Bloomberg, Man GLG; as of September 2022.
In a world of higher but falling inflation, we see a renewed opportunity in Growth names, especially in northern Asia. This is understandable: in a world of higher inflation, the discount rate on longer duration cashflows is correspondingly higher, leading to a lower present value. If inflation does peak, longer-duration assets may rally once again. However, to avoid a naked factor bet, it is imperative that managers do not blindly buy the factor, but instead earn their fee, using a deep fundamental research process to find growing companies at an attractive price point. After all, if multiples compress, the only way for firms to outperform is to generate more profits. To this end, we have a positive outlook towards healthcare stocks in particular, and see multiple names which may have the ability to offer idiosyncratic returns. In the wake of the Covid-19 pandemic, demand for high-quality health care is increasing, and not only in a clinical setting. Sourcing and procurement have come under increased scrutiny during recent supply chain squeezes. Likewise, the pandemic has shed a renewed light on the importance of ‘smart’ health care, with patient monitoring devices now a growing market. In contrast, we remain cautious on many tech names, particular those still vulnerable to a changing regulatory climate. While long duration assets may stage a comeback, we remain convinced that being selective will continue to pay dividends.
While long duration assets may stage a comeback, we remain convinced that being selective will continue to pay dividends.
Another sector we see long opportunities is the Indian telecoms market, which is undergoing a period of consolidation, due to a change in pricing dynamics. After the entry of Jia into the market in 2016, prices for minutes and data collapsed as firms competed aggressively to increase the size of their customer base.5 This led to a wave of consolidation, in which a market of 16 providers dropped to four. As a result, prices are rising again and with mobile phone usage now endemic, we see a similar dynamic to consumer staples firms, with telecoms firms able to raise prices in line with inflation.
In southeast Asia, we feel that we may be seeing a story of burgeoning domestic demand. If we do see muted goods inflation, and Asian workforces filling the DM labour shortage, we could well see rising disposable incomes. We therefore feel that consumer discretionary firms have an opportunity to outperform, taking advantage of increased domestic demand even if we see declining DM demand for exports.
Conversely, there are also many opportunities on the short side. Financial stocks, many of which are exposed to DM interest rates, may be set to struggle in the short term if the Fed continues or accelerates its hiking cycle in an attempt to contain inflation. Indeed, EM Asian banks may face the worst of both worlds: net interest income is also likely to be squeezed if domestic central banks cut rates to stimulate local growth. Caught between the rock of a global hiking cycle and hard place of a domestic rate cut, the outlook for financials may be poor.
Conclusion
Despite fears of the end of the economic cycle in DM, the picture in EM Asian equities is much more positive. Indeed, after a turbulent few years, we may be looking at a period of relative stability. While reopening and resurgent policy support in China, lower inflation and a better growth environment support the region’s narrative in relative terms, we remain focused on our key driver, earnings revisions. These reveal opportunities in key areas, such as healthcare, telecoms, and consumer discretionary, and should be enough – irrespective of macro movements – to allow active managers the room to make the most of the region’s turning point.
1. https://www.nature.com/articles/d41586-022-01690-3
2. https://www.plenglish.com/news/2022/09/26/china-approves-second-homegrown-antiviral-pill-to-fight-covid-19/
3. https://www.cnbc.com/2022/08/22/china-slashes-lending-rates-one-week-after-surprise-cuts-in-key-rates.html
4. https://www.bbc.co.uk/news/world-europe-63071552
5. https://telecom.economictimes.indiatimes.com/tele-talk/resilience-re-consolidation-and-reality-of-the-telecom-sector-in-india/4895
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