2019 has been a challenging year for Asian and EM equity markets. Global growth has decelerated over the last 18 months, with manufacturing output growth undershooting relatively solid final demand growth in the developed world.
There are several reasons for this: the lagged effect of China’s earlier policy tightening; a weak auto cycle in many countries; and an inventory correction as companies hold less inventories due to uncertainty surrounding the trade war and tariffs. Weaker global growth has led to a dispersion in valuations between stocks and markets, with some value/ cyclical stocks being excessively penalised for the lower growth environment.
In 2020, we expect the trade negotiations to continue to have a significant bearing on markets returns. The outcome is unpredictable and there is a danger that tensions could escalate further. The Trump administration perceives the rise of Asian technology as a threat, particularly Chinese technology, and this backdrop is likely to persist as China continues to spend on semiconductor development and 5G. The US is likely to remain wary of allowing China access to US technology. Recent news flow, however, has turned more positive, and in our view, a partial resolution is the most probable outcome. If we do see some clarity on tariff rules, companies will be encouraged to start investing in their businesses again.
The Chinese economy has appeared relatively robust but has continued to slow. We do not expect the authorities to ease aggressively as they attempt to strike a balance between maintaining an acceptable level of economic growth whilst managing financial risks in the economy. However, we believe the lagged impact of previous policy tightening on economic output is close to disappearing and China’s growth should improve in the medium term helped by supportive economic policies.
Turning to Korea, the equity market is cheaper than it was in the Global Financial Crisis. While sentiment has been impacted by slowing Chinese growth and trade tensions, Korean government policy has also had some unintended negative consequences. For example, the minimum wage was increased by 29% in the government’s first two years which led to a decline in job growth. However, we believe domestic economic weakness may encourage the government to re-examine its policy stance and introduce more effective measures to stimulate the economy. If this takes place alongside an improvement in China’s growth outlook and trade relations, then we believe investors will pay more for Korean earnings.
Elsewhere, opportunities have emerged in India due to the current economic slowdown. This country offers one of the best structural growth stories in Asia, supported by a government that is bringing about tangible structural change. Historically, it has been a challenge to find undervalued investment opportunities in high quality businesses. However, recent market weakness has resulted in new stock ideas which are largely insulated from external trade war-related pressures. Also, the private banks are currently in a position to increase their market share profitably, as their competitive environment remains weak. In particular, the state-owned banks, which we do not favour, are constrained by asset quality problems and weak balance sheets, while the expansion of non-banking financial companies (NBFCs) is hampered by higher wholesale funding costs due to funding pressures.
Other opportunities can be found across the region among companies displaying strong balance sheets, improving free cash flow generation and healthy dividend yields. These can be located within the technology sector in Taiwan and Korea as well as the consumer sector in China. Also, selected banks and insurers display these strengths, particularly those that have stable core profitability.
So, in summary, although the geopolitical outlook in Asia remains clouded, we believe there is potential for some improvement in trade and more supportive policy measures to support economic growth, particularly in China and Korea. We would expect to see economic fundamentals start to bottom out and the divergence between manufacturing output and final demand begin to reverse. This is important for Asia as earnings revisions tend to be correlated to the global manufacturing cycle. As the outlook for earnings improves, this should support Asian equity returns and the value/cyclical elements of the market in 2020.
The two largest economies in Latin America, Brazil and Mexico, continue to attract our interest. While positive sentiment towards Brazil has been bolstered by Congress finally approving the government’s pension reform agenda - a necessary development in our opinion for public-debt sustainability – we believe events in Mexico are not receiving the full credit they deserve. After a shaky start to the presidency which saw Mexico’s incoming leader, Andrés Manuel López Obrador (AMLO), cancel a new US$13.3 billion mega-airport, he has acknowledged that it is more conducive for the government to work with, rather than against, the private sector. Initial fears that AMLO’s administration would be profligate in their spending plans have not materialised. This is reflected in the passing of a conservative 2020 budget, which showed a primary surplus. Furthermore, a strong macro approach has taken the sting out of inflation and allowed the Bank of Mexico to cut interest twice since August 2018 – moves which are likely to support real wage gains in 2020. Against this backdrop, we believe that markets are discounting too much negative news on the country’s prospects with equity valuations remaining below their long-term historical averages.
We believe that Russia can be a beneficiary from the US-China trade war. After the Mueller report came out, US focus has shifted away from Russia to China, Iran and the Gulf region. This has reduced negative sentiment and with sanctions risk no longer looming, we can refocus on Russia’s improving fundamentals. The financial health of the country is strong with both the fiscal and current account balances in surplus while the Russian economy is also less sensitive to oil prices than it was in the past. However, we believe this supportive backdrop has not filtered down yet into Russia’s equity markets where valuations continue to look attractive. In absolute terms, the country remains the least expensive market among emerging markets, trading on a 2020 price earnings ratio of 5.3x – a 22% discount compared with its 15-year history. In our view, Russia also currently offers the best dividend yield of any major emerging market. This might provide interesting investment opportunities.
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