Risk assets, including global equities, had a great start in the first month of this year, only to lose some lustre when the market reset expectations for a potential pivot in the Fed’s rate hiking cycle after a series of strong US economic data. The latest developments reaffirm our view that investors should stay vigilant and take a defensive investment approach this year, built on our belief that the market could be volatile in light of crosscurrents facing the economic environment, geopolitical tensions, and corporate earnings. We recommend using the recent pullback to add to select pockets of investment opportunities: Asia is one of them.
Many investors are sceptical of this call. A key reason behind this scepticism is recency bias. Asia (excluding Japan) equities had done poorly and underperformed other regions for over two years in a row. This often leads many investors to extrapolate the past years’ trends into the foreseeable future. Also, following the aggressive monetary policy tightening by the US Federal Reserve over the past year, many fear that economic conditions in the US would worsen, clouding the outlook of many export-oriented Asian economies.
Our argument for Asia
We argue Asia ex-Japan will outperform other markets notwithstanding these challenges. Our base case assumes a mild recession in the U.S. and Europe this year, while Asia is likely to be relatively unscathed, helped by China‘s economic re-opening and policy support. To us, the recent USD strength is more of a multi-week phenomenon than a sustained uptrend. With the Fed expected to keep rates higher for longer, this will likely re-ignite fear about a recession sooner or later. As US interest rates start to peak and real interest rate differentials compared with other markets narrow, the greenback’s supremacy which has persisted for years would likely begin to turn. This should augur well for Emerging Markets, including Asia ex-Japan, enticing global funds to diversify outside of the US. Emerging Asia, including China and Southeast Asia, is one of the regions where the global investment community has been notably underweight, thereby making this market a prime beneficiary should the Dollar sustainably weaken.
Zeroing in on China, we see more pro-growth policy signals emerging, ahead of the “Two Sessions” scheduled to be held from 5 March. Following stronger-than-expected January money supply and new loan growth, the PBoC injected over RMB 600 billion in liquidity via reverse repos in mid-February to support the economy. With the Standard Chartered China Small and Medium Enterprises Confidence Index (SMEI) rebounding to expansionary territory in February, we are optimistic about China’s growth outlook this year.
Some positive drivers in Asia
Almost 85% of Asia USD bonds are issued by the region’s investment-grade corporates. The relatively high credit quality of these issuers makes them far less susceptible to credit default risk facing higher-risk bonds in the event of a recession. Also, these issuers are slated to benefit more from Asia’s recovery boosted by China’s re-opening and economic recovery.
China equities account for roughly 40% of the MSCI AC Asia ex-Japan index. We expect China to be a primary contributor to the region’s equity returns this year. China equities possess room for re-rating, thanks to the earlier-than-expected ending of mobility restrictions and rising policy support for technology companies and property developers, apart from their reasonable valuations.
Balancing exposure to onshore and offshore China equities
We favour balanced exposures to both China onshore equities (A-shares) and offshore equities (including Hong Kong-listed H shares and U.S.-listed ADRs) as we see unique drivers for each group. A-shares are more leveraged to mainland China’s domestic recovery. Lingering risks facing pillar industries such as the property sector reinforce our belief that more policy support measures will emerge in the ensuing months to revitalize the economy.
As for offshore equities, fund managers have been underweight relative to the benchmark in recent years, as heavyweight offshore equity constituents were severely impacted by policy uncertainty and US-China geopolitical tensions. While we see increased clarity on China‘s policy focus, the Sino-US friction has remained (and will likely stay) elevated heading into the 2024 US election. Any flare-up of tensions tends to suggest outperformance of onshore A shares to offshore equities, the latter being more sensitive to global fund flow. That said, any short covering in reaction to better earnings reported by Chinese ADRs could point to a narrowing of the current underweight gap in Chinese equities by global funds. This is likely to bring in strong fund flow into the Hong Kong and US-listed Chinese equities, both of which are still trading at a steep valuation discount relative to history.
From a sectoral standpoint, we prefer to be selective, with a focus on areas where we see (1) re-rating potential and (2) where earnings outlook improvement has yet to be priced in. The sectors we see the most potential in China are communication services and consumer discretionary. These industries should benefit the most from the government’s increasingly supportive policies and the ending of mobility restrictions. Included in communication services are mobile game developers whose profit outlook is poised to surprise positively with a resumption of new online game approvals. Meanwhile, consumer discretionary sectors such as tourism, electric vehicles and online retail are expected to recover most noticeably, as the economy normalizes after the pandemic.
Within Asia ex-Japan equities, India is the second largest market and plays a natural hedge against any China specific risk. Valuation admittedly is not cheap, despite the underperformance of late. However, India equities remain supported by resilient earnings growth, particularly of the large-cap domestic-oriented sectors, such as financials, industrials and consumer staples.
The need for diversification
With the argument for Asia done and dusted, where are the risks to our calls? They include a resurgence of COVID infections and geopolitical risks, such as the prolonged Russian-Ukraine conflict which could exacerbate and spur demand for the USD as a safe-haven. Against the current backdrop, we consider it more appropriate to broaden defensive exposures beyond the Dollar to gold, quality government bonds, and the Japanese Yen.
Last but not least, we cannot emphasise enough the importance of diversifying investments across asset classes, currencies and geographies, so as to build an “all-weather” portfolio and fortify against further surprises.
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