For all the noise that has arisen out of this region, we remain constructive on its outlook. Looking past the political turmoil (trade tensions, the U.S.-North Korea summit, Japanese Prime Minister Abe’s cronyism scandal), our assessment is that the fundamentals remain intact. Economic growth looks resilient at mid-year after having decelerated in the first half of 2018, and corporate earnings expectations are in an upgrade cycle for many countries in the region.
Let’s start with China, where concerns around debt and the potential for escalations in the rhetoric around trade negotiations have placed pressure on the equity markets. But looking past the news headlines, we see an economy that continues to be on a good footing. Private investment is growing, and it is likely that we will see an increase in Chinese government spending to further boost activity and confidence. The inclusion of China A-shares in the MSCI indices, according to some industry analysts, will draw an estimated $20 billion of foreign capital into Chinese equities through this year.
Developing Asian economies have managed to weather the storm of rising U.S. interest rates and a rising U.S. dollar much better than their counterparts in Latin America and Eastern Europe. India and Indonesia have each raised interest rates, which we view as a combination of defending the currency and acknowledging economic activity. Overall, the elevated level of trade within the region, combined with our constructive outlook for China, leaves us with a positive outlook for developing Asia.
Moving across to Australasia, we continue to expect Australia to outperform New Zealand. Economic growth in the former is solid, underpinned by public investment, external trade and buoyant business confidence. Looking at corporate performance, we see the potential for positive earnings revisions, particularly in mining and resource companies. We view the weaker-than-expected labor market as temporary and expect to see a rebound in the second half of 2018. This should support the Australian consumer, who has been cautious given high levels of debt and muted wage increases. In New Zealand, in contrast, weak business confidence and a slowing housing market remain headwinds. Political uncertainty in New Zealand has dissipated following the release of a fairly sensible budget from the new Labour-party government; however, uncertainty lingers in several key policy areas.
Both the Australian and New Zealand currencies have been pushed down by the negative rate differential, which we highlighted in our previous quarterly outlook report. We reiterate our view that this paradigm is unlikely to reverse over the rest of the year.
Japan continues to offer one piece of positive data for every piece of negative data. On the positive side, we have seen very strong earnings growth, the first signs of decent wage growth, a strong labor market and robust business confidence. On the other hand, weak consumer confidence has translated into poor retail spending and household consumption; while rising oil prices are not great for a country that imports nearly all its oil. We expect consumer confidence to rebound as higher wages flow through to household balance sheets, but further increases in the oil price will be a drag and overall upside for the economy is limited from here. The support from the Bank of Japan should remain for some time, as we do not expect any change in policy for this year, at the very least.
The key risk to the Asia-Pacific region, in our view, continues to be the implications of trade rhetoric escalating into action, which likely would most impact China. Our view remains that the threats of tariffs are primarily negotiating gambits, and that we are unlikely to see trade barriers being permanently erected. Further rise in the U.S. dollar (which is not our base case) would also be a risk to the region.
For regional equities, we assess business cycle, value and sentiment considerations as follows:
- Business cycle: We expect broad-based growth and positive earnings revisions for the region, with a preference for developing Asian countries over developed ones.
- Valuation: Valuations are fair priced to slightly attractive across the region. We continue to like Japanese valuations and believe that part of the rise in Japanese profit margins is structural (rather than cyclical). Australia is close to fair value in our view. Developing Asia looks attractive, with the caveat that China H-shares are expensive due to the Chinese tech names.
- Sentiment: Momentum has been taken out of the market recently, in part due to the rising U.S. dollar. We aren’t seeing any signs that the market has moved all the way to oversold; however, we have seen withdrawal of capital from emerging Asia bond and equity funds, particularly during weeks of general risk-off sentiment. The economic surprise index as shown in the chart above is fairly neutral for Asia-Pacific ex-Japan, and we would expect this to firm over coming months, which should be positive for regional equities.
- Conclusion: We expect to see solid performance out of the economic data and equity markets in the region, underpinned by strong Chinese activity, robust global growth, and supportive policy. We should see positive earnings revisions across much of the region, which should boost equity markets. An escalation in trade tensions or further strengthening in the U.S. dollar remain key risks.