Exceeding diminished expectations
Asia-Pacific has been heavily hit by concerns around trade wars, a strengthening USD, and a set-back in commodity prices in recent months. The “emerging market” characterization of much of Asia has also seen the region tainted by association, in investors’ minds, with troubled developing economies elsewhere such as Argentina, Turkey and South Africa. The outlook remains fragile, particularly as U.S. President Trump has now threatened tariffs on $467 billion of Chinese goods – a remarkably precise number which amounts to all Chinese exports to the U.S. With further negative announcements now almost mathematically impossible, we believe most of the bad news is now in the market. As a result, we could see more investment opportunities within developing market equities in the region as the situation unfolds. Among developed countries, we prefer Japanese equities.
The Chinese economy has shown signs of slowing through the first half of 2018, most notably in the money supply and in capital investment. This has been driven by a deleveraging push by authorities, as well as by some anticipatory concerns around the impacts of the trade wars. The Chinese government already has announced stimulus measures, including infrastructure bonds and monetary policy easing, which we expect will stabilize growth through the rest of 2018. Regarding the impact of U.S tariffs, a 10% general rate on the $200 billion announced so far should be largely offset by the year-to-date deprecation in the yuan. A higher rate and/or a broader range of goods (both of which have been flagged as potential actions by the Trump administration) are the key risk, should they fully eventuate.
Outside of China, developing Asian currencies have been sold off by the market, most notably Indonesia and India, due to their high current account deficits and national indebtedness. In our view, this sell-off has been driven more by sentiment and herd behavior than fundamentals, as both economies remain fairly solid. Weakness has been justifiably very mild, compared to sell-offs in the developing market currencies in Europe and Latin America.
Australian growth has been impressive so far in 2018, but we believe that this economy may have reached its peak. The headwind of falling housing prices continues to increase, and uncertainty around the strength of the Australian consumer remains. On the positive side, business confidence remains elevated. Recent political events (i.e. the deposing of the prime minister) are immaterial in our view (given the continuation of policy), however we are getting closer to the 2019 Australian federal election, which will likely inject some volatility into markets.
Across the Tasman Sea, our outlook for New Zealand is deteriorating. In recent years, the country’s economy has been driven by increases in immigration and housing, both of which are now set to slow (due in both cases to expected discouraging government policy). Policy uncertainty has already significantly damaged business confidence, which is at 10-year lows, according to the ANZ Business Outlook Survey as of September 2018. We expect the Reserve Bank of New Zealand to remain firmly on hold for the next year, with a heightened risk that the next move in interest rates could be a cut. Despite this weak domestic backdrop, the New Zealand equity market has been one of the top performing asset classes globally year to date, driven by a weaker New Zealand dollar (which boosts the elevated levels of foreign revenue in the equity market).
As a result, we are cautious on both the Australian and New Zealand dollar. We believe slowing economies and diminished interest rate differentials will likely remain a drag on both currencies.
In Japan, the economy is starting to show signs of better positive momentum as we move into the fourth quarter of 2018. Capital investment and consumption growth are being underpinned by strong levels of business confidence and rising household income, respectively. The Bank of Japan has taken a very small step away from extreme ease of settings in monetary policy. We expect to see further gradual moves over the year ahead, as inflation slowly edges higher. For this reason, we’re cautious on Japanese government bonds, which we view as very expensive and with an elevated level of asymmetry with equities. However, we are quite positive on the yen.
MSCI country indexes: 12-month ahead earnings forecasts
Source: Thomson Reuters Datastream, as of Sept. 15, 2018. Indexes are unmanaged and cannot be invested in directly. performance quoted represents past performance and should not be viewed as a guarantee Of future results.
For regional equities, we assess business cycle, value and sentiment considerations as follows:
- Business cycle: Chinese economic stimulus should provide a small boost to activity in the region, while other developing economies remain in decent shape. We expect robust performance out of the Japanese economy through the rest of 2018 and 2019
- Valuation: Australian and New Zealand equity markets remain expensive in our view, particularly the latter. Other markets in the region continue to offer fair to good value. The MSCI Asia-Pacific ex-Japan Index is trading at 14X earnings as of September 12, 2018, which is not particularly high. Japanese equities, using the Nikkei index, are trading close to fair value.
- Sentiment: Sentiment is negative for most developing markets, with U.S. dollar strength weighing on their currencies. However, we think most of the risks to our outlook have now been priced in as the fourth quarter begins. Sentiment remains neutral in Japan and Australia, while we are seeing signs that the New Zealand equity market may be overbought.
- Conclusion: Our positive outlook on the region has become more cautious, given the heightened risk of a trade war. Fundamentals remain decent, and we believe diminished expectations for future activity have a reasonable chance of being exceeded.