Outlook 2019: Asian ex Japan equities

• Asian equities have cheapened providing selective buying opportunities
• There are promising opportunities across various areas including businesses benefiting from long-term regional trends, domestic-oriented companies, exporters and banks
• Uncertainty related to China, as well as a stronger US dollar and higher US interest rates are key risks to the region

It’s been a poor 2018 for Asian equities. Hampered by trade tensions, central bank tightening and a strong US dollar, the MSCI AC Asia Pacific ex Japan Index has fallen 11.3% (in USD to end of November). Can the tide turn for the region in 2019? Here, four of our Asian fund managers share their different perspectives.

The outlook for Asian growth has deteriorated due to four factors:

1. The slowdown in China

2. The impact of higher oil prices

3. Rising interest rates in markets like India, Indonesia and the Philippines

4. The escalating trade war between the US and China

In the near term, market performance is likely to remain dominated by the interplay of these same factors.

On the positive front in China, the authorities have moved to a slightly more pro-growth stance, with recent cuts in reserve requirements and encouragement for the banking sector to lend. Meanwhile, expectations are increasing for further cuts in taxes and also a pick-up in infrastructure spending. This slightly looser policy will take time to show up in the macro data, with headline growth still expected to slow in coming months, but the change in signalling from the authorities to support growth is still important for markets.

Oil prices have also retreated from their recent highs, which alleviates some of the pressure on the more fragile emerging economies and will reduce the drag on consumption.

At the same time, US bond yields and interest rate expectations have moderated slightly in the last few weeks, partly in response to the crack in the US stock market and also due to the ongoing slowdown in growth outside the US. All of this is helping to stabilise sentiment towards risk assets.

Much harder to read is the outlook on the trade front. The recent truce apparently reached between the US and Chinese presidents at the G20 meeting at the end of November was well-received by markets. But there is little confidence that this is the end of the trade frictions, given the longer-term concerns held by many in the US over China’s threat to US national security on different fronts.

Given this difficult backdrop, we continue to tread carefully in equity markets and have not moved to significantly increase risk recently despite the correction.

As bottom-up investors, our focus remains on those businesses best-equipped to survive the current slowdown and also exploit the favourable longer-term trends we continue to see in the region. These trends include the continued growth in domestic consumption and growth of service sector industries in countries like India, Indonesia and China. Other themes include the technological leadership of Chinese players in the online space, or the growth potential for industry leaders in the Korean and Taiwanese tech hardware sectors.

On the valuation front, Asian equities in aggregate now trade close to the levels seen during the last period when regional markets experienced a downdraft in late 2015 and early 2016. At this level, they are beginning to offer some value.

Despite the trade issues, we are still finding a number of good opportunities among selected Asian exporters. We like companies that deliver a high level of added value with their products and that have complicated supply chains. This makes it is very difficult to source alternatives for their products elsewhere.

Promising investment opportunities are also showing up among a number of domestically-focused growth stocks in sectors like leisure, healthcare, internet services and education. Following the market falls of 2018, these have come back to attractive levels.

We also still like a number of the banks across the region. These are very strongly capitalised, meaning they look capable of absorbing losses if they need to. We don’t expect to see a significant increase in losses due to non-performing loans, when payments are being missed, but an attractive combination of solid growth and undemanding valuations.

Given the uncertain environment, Asian management teams are generally being selective in their capital spending decisions at a time when balance sheets (at least for companies we prefer) look robust. Consequently, free cash flow generation is running at historically high levels, which should underwrite resilient dividends.

With global equities teetering on the brink of bear market territory (a 20% decline), the braver contrarian investors invariably ask, “Is it time to buy?” Well, to answer that we always turn to valuations.

For this, we use two main indicators: one focused on the top-down, a broad assessment of the stock market across the region as a whole, and one on the bottom-up, looking at individual businesses and stocks.

Looking at the former, the sharp drop in the regional index in October has brought us just a short throw away from the level that has typically caused us to turn more positive on Asian equity markets. Unfortunately, our bottom-up valuation indicator is not sharing the same level of enthusiasm. Despite outsized declines in some individual stocks, only 58% of the stocks covered by our analysts are currently showing upside to their fair values. This number sits just slightly above its long-term average and remains some distance away from the 70% that we look for to signify an abundance of positive absolute return opportunities. Based on our calculations, a further 14% correction in stock prices from here, all else being equal, will be required to get us there.

However, valuation measures relate the share price to an underlying fundamental variable, whether that is earnings, dividends, sales or something else. While the price component remains the more dynamic part, the fundamental portion can shift over time too. Today’s cheap markets can look expensive tomorrow – even if prices are unchanged – if the fundamentals deteriorate significantly.

Compared to previous earnings downgrade cycles – including the global financial crisis and the eurozone debt crisis – the current one looks to be still in its infancy in terms of both magnitude and duration.

At its worst around the time of the Asian crisis, Asian earnings almost halved over a period of four years.

China is increasingly finding itself in an economic quagmire, with the risks of either a currency devaluation or an economic recession rising. While neither is a base case scenario for us, if one or other does materialise it will be painful for Asia. Given the size of the Chinese economy today, and the amount of intra-regional trade, the region will be lucky to escape with just a cold, and not something a lot worse, if China sneezes.

Given this backdrop we recommend investors tread cautiously and watch economic trends in China very closely. Assuming the tail risks highlighted above do not materialise, we will continue to gradually add to our favoured names on weakness. These are primarily in those markets offering the most upside on our long-term valuation models - Australia, Hong Kong and Singapore.