Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Tai Hui, chief market strategist for Asia Pacific, JP Morgan, asks is the Asia equities bull spooked or set to run?
After several lean and difficult years for Asia and emerging market equities, 2017 saw the convergence of a number of trends that produced a stellar performance year. The recovery in global trade in late 2016 and 2017 coincided with the revival of Asian corporate earnings, which were provided a much-needed cyclical boost by the region’s export performance. A number of other structural trends also played a role, including the rise of consumers in China, India and ASEAN, as well as the demand for infrastructure in the region.
What is the Outlook for Asian Equities?
If 2017 was a year where earnings rose from the ashes, 2018 and 2019 are likely to be years where headline earnings growth slows down, but is more evenly distributed across sectors. The energy and materials sectors have rebounded in 2017 from the low base set by earnings recessions in earlier years. Technology, led by hardware manufacturers in Taiwan and South Korea and internet companies in China, also enjoyed a very good year. These impressive headline numbers would be hard to sustain in the next 12-18 months, but we would expect slightly more muted earnings performance to also be more evenly distributed.
For example, higher interest rates and stronger economic activity should help to boost the earnings of Asian banks and improve their credit quality. A stronger jobs market should help to boost consumption and demand for healthcare. Elections could also accelerate government spending and infrastructure investment. This is a critical foundation to our constructive view on Asian equities.
Risks on the Horizon
Given that our optimism on Asian equities is predicated on the continued health of the global trade cycle, weaker global growth and protectionism are obvious threats. However, given the current growth momentum globally, upside risk to inflation is more likely than recession in the next 18-24 months. The risk to Asian equities could therefore come from a much more aggressive US Federal Reserve when it comes to monetary policy normalisation.
Instead of three to four rate hikes in 2018, a faster pace of policy rate rises induced by surprisingly strong inflationary pressure could unsettle the global equity market, including Asia. This could also potentially bring back a strong US dollar, which historically acts as a headwind to emerging markets and Asia. A strong US dollar environment could put more pressure on EM and Asian central banks to raise interest rates in tandem with the Fed to protect their own currencies, especially for those with current account deficits.
However, we expect US inflation to grind higher in a gradual manner, instead of a sharp spike, and the Fed should have sufficient leeway to communicate with the market to prevent any knee-jerk reaction.
As for protectionism, Washington has already fired its opening salvo with tariffs on imports of solar power panels and washing machines. China has retaliated with an anti-dumping investigation into imports of sorghum, used for feeding livestock, from the US The next flash point could be the result of the US Section 301 Intellectual Property Investigation, under which the US is accusing China of intellectual property theft from US companies operating in China.
However, we expect any trade tensions to be product or sector specific, and don’t see a comprehensive tariff on all Chinese exports to the US Punitive tariffs on a broad range of Chinese exports to the US could exacerbate the risk to inflation in the US, which would hurt consumers.
Expect Some Volatility
We believe the outlook for Asian equity remains constructive for at least the next 12-18 months. The big difference in return performance between 2017 and previous years has been earnings. Although 2017’s earnings growth was artificially boosted by a low base and will be hard to duplicate, the current global growth momentum would imply that the current market consensus of 10-12% earnings growth for the next 12 months is reasonable. As for valuations, the current level of Asian equity valuations is in line with their long-term averages, implying there is some buffer to absorb short term shocks.
For international investors, Asian equity markets typically represent a high beta trade in the global equity sphere and deserve to be part of their portfolio, albeit with higher volatility relative to developed markets. With in-depth research and insights to fully understand the industry landscape and corporate governance philosophy, this can potentially enhance their returns via additional alpha generation.
Disclaimer
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