World trade is weakening, and regional economic growth is slowing – so how could this be good news for Asian exposure?
History shows us that the best returns are to be made following weak points in the cycle and peak pessimism and there certainly isn't a lot of optimism for Asia and EM right now.
World trade is weak. It used to grow twice as fast as global GDP and is now no longer growing. The JPM global manufacturing PMI is now below 50, a sign that industries are contracting. Unsurprising in this context that the IMF is again downgrading its global growth forecast (3% for 2019). All these indicators have hit post-GFC lows.
That's a difficult backdrop for Asian equities given their strong manufacturing base and large exposure to exports, which in turn tends to affect earnings growth expectations (currently 2% for 2019; 14% for 2020). The 2019 earnings downgrades have eased but the asset class is still susceptible to swings in sentiment – with trade tensions the obvious overhang. Also, domestically, Asian economies have been slowing, notably China and India given the clamp down on shadow banking which has tightened funding sources for smaller firms. If all this sounds a bit gloomy, there are two reasons to be optimistic.
Firstly, history shows us that the best returns are to be made following weak points in the cycle and peak pessimism and there certainly isn't a lot of optimism for Asia and EM right now. Figure 1 shows the negative correlation between US ISM Manufacturing PMI and subsequent 12 month returns in Asian equities. There's certainly no guarantee that this pattern will repeat itself, but it shouldn't necessarily be ignored, especially when combined with relatively low valuations which typically lead to better future returns. Asia, as measured by the MSCI Asia ex Japan index, has already underperformed the S&P 500 by 45% over the last 5 years, leading to the steepest P/B valuation discount since 2001 (55% discount). The forward P/E discount is 25%. The P/B ratio of our Asian portfolios is slightly above book value which is unusually low.
Figure 1: Contrarian strategies of buying on low ISM readings have historically led to good subsequent 12 month returns in Asia
Source: Datastream, as at 30/09/19.
Secondly, it is worth keeping in mind that when data is at its worst, policy action tends to be most significant. We are not contemplating a global coordinated policy response given how self-centered politicians have become but Asia still has some ammunition in the short term and structural drivers in the long term.
Indeed, we have seen a series of interest rate cuts across Asia this year. This has been made easier with the 'Fed pivot', allowing Asian central banks to at least match the Fed's interest rate cuts without compromising their currencies. In fact, Asian currencies had already corrected meaningfully since 2018 making this risk less potent. Non-Asia EM currencies have adjusted even more with Argentina and Turkey well known basket cases.
Also, thanks to prior interest rates hikes and much contained inflationary pressures, Asia's real interest rates are still positive – around 1 or 2% compared to the negative real rates seen across advanced nations. This provides Asian central banks still some room for manoeuvre.
The People's Bank of China has already trimmed prime lending rates and cut banks' reserve requirements (RRR) several times this year. RRR is still a high 13% suggesting more cuts are possible as a way to inject liquidity into the system. The Yuan has also been allowed to depreciate against the US dollar and the trade weighted basket of currencies. The Chinese authorities have shown no appetite to re-lever, let alone bail out the global economy, however, more 'fine-tuning' is not out of the question if the unemployment rate deteriorates (currently 5.2% in urban areas).
This could include Fiscal policy action. So far:
- In China, around RMB2 trillion of tax cuts were announced to support consumer demand and manufacturers,
- More recently, the Indian government cut its corporate tax rate from 30% to 22% – providing an uplift to earnings and boosting India's competitiveness in the medium term. The Modi Government is also entertaining the possibility of cutting income taxes as an immediate support to consumption,
- Weakness in global growth still affects Asia (and EM) significantly and that is unlikely to change anytime soon. However, it is when sentiment and valuations are depressed relative to history and other asset classes that it's a good time to re-consider one's exposure to Asia. The region is likely to become increasingly prominent in a more polarized world: it currently represents 1/3 of global GDP; 2/3 of global GDP growth; it is technologically competitive; has a massive consumer base; and is increasingly self-reliant, with China at its epicenter.
We continue to hold a portfolio of around 60 Asian companies who we believe can benefit from Asia's strong attributes, and we can find opportunity during periods of pessimism.
The value of investments and any income will fluctuate (this may partly be the result of exchange-rate fluctuations) and investors may not get back the full amount invested.
As a large portion of the strategy is invested in less developed countries, you should be prepared to accept significantly large fluctuations in value.
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Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire RG9 1HH, UK. Authorised and regulated by the Financial Conduct Authority.