Asia Pacific: And the show rolls on
We continue to expect solid growth and low inflation out of Asia Pacific in 2018. The Chinese government’s economic growth target indicates another solid year, which we anticipate will be achieved with some mild attempts at reform. We expect the Japanese and Australian economies to continue to tick along. A move by the U.S. toward protectionism is a key risk to the region, although this is not our base case.
We remain constructive on the Asia-Pacific region and see no sign that this view needs to be moderated. The tailwinds of global growth and an expanding middle class in the region are outpacing concerns around high debt levels, notably in China. Earnings expectations for the Asia-Pacific region (excluding Japan) remain fairly modest and achievable in our view, and we expect to see upward revisions in coming months. As always, the risk of a China slowdown remains, however the consolidation of the government suggests to us this has mitigated at the margin. A shift towards protectionism is a growing risk, despite fairly high intra-regional trade, although our base case is that we will not see a full-blown trade war.
The Chinese government has announced that growth will continue to roll on, reiterating its 6.5% GDP growth target for 2018, albeit with a slightly tighter fiscal stance. Our reading is that they are anticipating further pick up in private activity, which provides them with the opportunity to rein in the deficit. More broadly, activity in China has continued to be impressive, despite the environmentally driven capacity shutdown that has been in effect since the beginning of the winter heating season. Looking further ahead, significant supply-side reform is needed to allow for sustainable growth. We have yet to see many signs of this, but the consolidation of power that has been seen should provide the opportunity. We would expect this reform will include efforts to reduce the debt levels, but not to the extent that it compromises growth.
Looking at other developing economies in the region, the outlook remains positive. In South Korea, a tight labor market has translated into elevated consumer confidence and robust retail sales growth. Monetary policy remains accommodative, although the Bank of Korea will likely move towards tighter policy as the year progresses. A similar story is playing out in India, with solid growth in retail sales being supported by strong industrial production and manufacturing, with monetary policy expected to tighten through the year.
In Australia, our ‘good, but not great’ theme rolls on for the economy. In New Zealand, further detail on immigration, housing and foreign investment policy changes from the government will provide clarity into the outlook. This activity in our view will mildly slow as population and housing growth cools. The main recent development is the negative spread that is now in place between the U.S. and both Australia and New Zealand, which is something that we haven’t seen in some time. On the short end, it is likely that this will remain through the year, given our view that the Fed will raise rates at least three times this year, while the Reserve Bank of Australia will hike twice at most and the Reserve Bank of New Zealand will leave rates unchanged. This should place some downward pressure on both currencies over the medium term.
We think earnings expectations for Asia Pacific (excluding Japan) are a bit cautious. The following chart shows I/B/E/S expectations1 of 12% growth (following last year’s stellar 23%). With the economic story expected to remain positive, and solid Chinese demand for regional imports, we think the market is being too pessimistic, and expect upward revisions as the year progresses.
In Japan, we believe that a slight moderation in headline Q4 GDP hid the strength of the Japanese consumer and the positive investment outlook. Buoyed by the tight labor market, and some very early signs of wage growth, we are seeing an acceleration in consumption spending. On the business side, elevated confidence and high capacity utilization should see a pick-up in investment, while 2020 Olympics-related spending should ramp up in coming quarters.
MSCI Asia-Pacific ex Japan Index: EPS growth
Source: Thomson Reuters Datastream, as of March 7, 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.
The strength of the yen, in our view, will be the major headwind that Japan will face. Japanese firms have been assuming a yen at around 110 USD/JPY in their forward estimates. As of March 15 it is at 106. We think the yen’s positive run can continue through the year. This will likely see some downward revisions to earnings guidance and forecasts, given roughly 40% of Japanese earnings come from abroad, although this will be offset to some extent by further strength in the domestic economy.
We wouldn’t be able to have a theme of ‘the show rolling on’ without mentioning the Bank of Japan, which continues to pursue a very accommodative monetary policy. There has been speculation that the BoJ is planning an exit strategy from the current policy stance. We think these expectations are a bit ahead of themselves, and see no change in monetary policy any time soon. Inflation remains very contained, with a return to 2% not expected until 2019 (which could prove to be optimistic). If inflation does reach 2% in 2019, the BoJ will have to also deal with the lift in the consumption tax, which is likely to be implemented in October 2019. Additionally, by reiterating a commitment to loose policy in the face of tightening policy in the U.S., the BoJ may be able to ease some of the pressure on the yen.
The key risk to Asia Pacific, and the global market more generally, is the heightened possibility of the U.S. engaging in some form of a trade war. We have recently seen the Trump Administration introduce tariffs on steel and aluminum imports. While this doesn’t significantly impact China, Trump has been very clear in targeting China as problematic. We also have an eye on the outcome of the U.S. government’s investigation of China’s intellectual property trade practices. Despite relatively high intra-regional trade (around 50% of Asia-Pacific trade is intra-regional), we believe an escalation into higher tariffs and a move toward protectionism would have negative consequences.
For regional equities, we assess business cycle, value and sentiment considerations as follows:
- Business cycle: Look for developing economies to continue to lead the way, with growing support from Australia (underpinned by public investment and a pick-up in consumption) and Japan (supported by very accommodative policy and Olympics-related stimulus). We anticipate positive earnings revisions for the region, focused in the developing countries.
- Valuation: Valuations within the region have become slightly less expensive following the February 2018 sell-off. Within the region, we believe Japan offers the best value. Within the developing countries, we see China mainland valuations as more attractive than the H-share2, due to the expensive tech names (Alibaba, Tencent, Baidu) being included in the H-share index.
- Sentiment: We have seen a deterioration in momentum, although it remains positive for the region. Equity flows remain healthy, indicating that there is still demand for Asian exposure from global investors. Signs that Asia-Pacific equity markets are overbought remain, restraining our sentiment view from being positive.
- Conclusion: We believe Asia-Pacific economic data and equity markets should see another solid year of performance as global growth underpins demand and monetary policy remains relatively accommodative. Valuations are looking less expensive following the February sell-off, with Japan standing out as offering fair value. A negative turn in the current U.S.-China trade discussions stands as a key risk.
1 IBES (also known as I/B/E/S) stands for Institutional Broker’s Estimate System. It is a database that basically compiles the analysis and forecasted future earnings of publicly traded companies.
2 H-shares are shares of a company incorporated in the Chinese mainland that is listed on the Hong Kong Stock Exchange or other foreign exchange. Although H-shares are regulated by Chinese law, they are denominated in Hong Kong dollars and trade the same as other equities on the Hong Kong exchange.