December 2016Investment insights
Tim Orchard, CIO Asia Pacific ex-Japan
It’s been an eventful year for Asia as markets were once more subject to the vagaries of shifting opinions. In the first half of 2016, investor focus remained on the potential fragility of China’s credit driven growth and this was a major driver of the region’s underperformance. However, these concerns dissipated in the second half of the year as the focus returned to relatively attractive valuations and the possibility of an upturn in the earnings cycle.
Over the longer term, investors should focus on the execution of various structural reform agendas in major markets. Progress has been made in India with major GST reform and the more recent decision to withdraw large banknotes from circulation in an attempt to formalize part of the unregulated economy. Whilst this will inevitably damage near term growth, it is nonetheless a positive reflection of Prime Minister Modi’s desire for reform. There has also been progress in reducing India’s twin deficits, inflation levels have fallen and the scope to cut interest rates further remains. Thus whilst the cyclical downturn may be prolonged and before long the issue of Modi’s re-election will start to concern the market, the longer term omens remain good. Similarly in Indonesia, with land acquisition reform and the recent tax amnesty, progress has been made.
In China, the balancing act between maintaining sufficient nominal growth whilst slowly rebalancing the economy away from credit driven fixed asset growth and towards sustainable private consumption continues. It is also clear that the opening of the domestic Chinese market to foreign investors continues, with increased QFII allocations and the Stock Connect programme being two recent examples. Once full fungibility between asset classes is achieved and domestic share classes are included in the various stock indices, China will the dominant part of the regional index.
In what appears to be an era of increasing geopolitical risk, these reform factors in Asia reflect a relatively benign political backdrop. Given the more tumultuous developments outside of Asia - be that the partial annexation of a European sovereign nation, Brexit or the short term policy uncertainty created by the US election result - it seems credible to argue that emerging Asia should not necessarily carry a significant corporate and political governance discount to her western brethren. Concerns have also been raised over Asia’s ability to cope with the spectre of higher US interest rates. Whilst this cycle may exhibit different characteristics, some comfort may be gained by looking at how markets faired in previous cycles: typically Asian markets have performed well in a rising US interest rate environment which perhaps reflects the fact higher rates typically reflect robust global growth.
Asia currently offers cheap valuations relative to the developed western markets, has made decent progress in its reform agenda and has suffered a cyclical downturn in earnings. Markets seem well positioned for long term growth.
John Lo, Portfolio Manager and Head of Equities Singapore
Markets underperformed over the first half of 2016 largely given heightened skepticism in particular towards China. However, moving into the second half of the year we saw Asian markets perform well supported largely by attractive valuations, an improving earnings outlook and positive signs on the macro front. Asia has become far more resilient against external shocks, as we have seen after Brexit and the run up to the US election. This is in part a result of an improvement in imbalances across Asia via structural reforms we have seen which have help boost long-term capital and productivity. Looking forward there continues to be several exciting developments on the policy and macro front in Asia that I believe will drive markets over the mid-to-long term. Reform agendas across the region particularly in India and China are seeing significant progress being made.
Looking at China there is a need to rely less on fixed asset investment and more on domestic consumption and looking at the evidence clearly over the last couple of year’s consumption numbers are starting to rise and this trend is likely to continue. This is and will be a significant theme over the next few years. Looking forward, it is likely we will see household income and consumption pick up as a recovery in corporate profitability boosts employers. There are interesting trends with the rise in affluent consumers, for example the shift to online shopping which is making e-commerce increasingly the common form. Additionally we are also seeing financial and other services emerging as new high growth areas of the internet economy.
In India, while there has been disappointment with regards to the pace of reform since PM Narendra Modi has taken over, largely down to elevated expectation. Looking forward the macro back drop is looking extremely positive, with the twin deficits being reduced, inflation falling and the scope to cut interest rates. In Korea, growth has remained relatively resilient in 3Q16 supported by domestic demand, despite the softer global trade environment. Currently there is some political uncertainty, I am looking at any market weakness as opportunity as I do find a number of quality companies there. These companies are advancing not only domestically but overseas with strong brands that mean their market share is continuing to expand.
Overall Asia remains very attractive on a number of measures versus the developed world – be it from a fundamental perspective or from a valuation point of view. Additionally earnings momentum in Asia is turning up, I believe we are seeing downgrades over the last 2 to 3 years coming to an end. This presents a very positive backdrop for stock picking in the region. My overall investment philosophy remains consistent, I believe over the long run markets will reward quality stocks and look to identify high return on capital, cash generative businesses which are reasonably valued on a cross–cycle basis. In the information age, having a “thinking” edge through qualitative analysis and understanding is just as important as quantitative analytics. Furthermore, stocks should drive portfolio returns; not companies, markets or economies. Short-termism is entrenched among investors & the investment industry and therefore sentiment and short-termism creates mispricing opportunities in stocks and industries for patient capital.
Jing Ning, Portfolio Manager – Fidelity China Fund
The Chinese economy has been in a muddling through stage since investment cycle peaked out in 2010. It will continue to remain so for the next 2-3 years. In 2017, Chinese policymakers are likely to maintain a pro-growth stance before the leadership changes in late 2017 and 2018. Monetary policy will shift back to a more neutral stance with inflation returning while fiscal policy will remain very accommodative. The sharp rise in property prices has put Beijing on alert and tightening measures will continue in the first half of 2017. However, given the disparity between property markets in higher tier cities with soaring property prices, and tier-3 cities and lower dealing with excess housing inventory, we are less likely to have uniform policy response such as across-the-board tightening. Measures aimed at addressing these issues are likely to be city specific, not of the type seen in the past and may require local government intervention.
Elsewhere, Chinese debt would also remain in focus. In my opinion, debt management in the SOE segment is likely to be the most challenging, as the NPL recognition is in relatively early stages and is expected to be spread over the next two years. The onset of supply side reforms this year is a positive step to potentially lead to the recognition and restructuring of SOE liabilities. Chinese banks have made progress in NPL recognition in the private sector over the last two years, and the local governments have also begun to address this issue with bond issuances. It is quite unlikely that there would be a liquidity crunch in China, with the People’s Bank of China being the largest shareholder in key financial institutions.
Nonetheless, long term investors in China will find opportunities not only in the structural shifts but also among beneficiaries of reforms. I believe that the management incentive programmes and supply side restructuring in SOEs will drive long term returns for well-managed businesses that may currently be out of favour. While the economic shift to ‘new China’ cannot be ignored, investors should also not overlook opportunities in traditional sectors that still continue to be the backbone of the economy. For instance, supply side restructuring in steel and coal will weed out the inefficient players, and I expect to see companies with balance sheet strength, healthy cash flows, strong management teams, and attractive dividend yields deliver returns.
I believe that the Chinese consumer is important –but it is also crucial to understand that consumer behaviour is changing at a fast pace. For instance, younger Chinese consumers have a higher preference for light luxury goods vs. high premium luxury goods; the newly affluent do not necessarily prefer to spend time in casinos and on gaming, but prefer to travel. It is important to make this differentiation.
Sandeep Kothari, Portfolio Advisor - Fidelity India Fund
“Indian equities underperformed Asian and global equities in 2016, despite strong economic fundamentals. Inflation has fallen from a high of 11% in November 2014 to about 4% in October 2016, making it possible for the central bank to cut interest rates twice in 2016. The country’s fiscal and current account balances also improved significantly and as a result the currency remained stable versus the US dollar.
Meanwhile the state of the real economy continues to be mixed. While there are green shoots appearing in domestic demand and exports and September quarter has seen corporate earnings growth pick up at its fastest pace in ten quarters, industrial production remains weak and corporate capex continues to stagnate at low levels.
We head into 2017 with optimism and some near term uncertainties stemming from demonetization and its impact on the economy. Note that the step is unprecedented both in terms of its scale and as a policy tool. The overall economic growth could slow down over the next couple of quarters, given that India is a pre-dominantly a cash-based and domestic consumption-oriented economy. However, the economy should recover in the second half of 2017. The Union budget would be critical to see if the windfall gains that the government gets out of this will get spent on infrastructure development and/or to recapitalize stressed public sector banks. Meanwhile, credit growth is also likely to pick up given that the banks have received a significant cash infusion in the form of low cost deposits making it possible for them to reduce their lending rates. Over the medium to long term, this step should help broaden India’s tax base and strengthen the organized economy.
What this bold move by the government also indicates is that India’s economic reform process is gathering pace. The nationwide goods and services tax (GST), another much-awaited high impact reform, is likely to get implemented in 2017. GST should ease the conditions for doing business and make the economy more transparent and efficient, helping improve profitability of Indian corporate sector.
Against this backdrop, I will continue to focus on high quality growth stocks, characterized by their higher returns on equity and free cash flows and lower debt. The recent correction has brought equity market valuation down to a more attractive level. From a bottom-up perspective, India remains a stock picker’s market with abundant opportunities due to wide disparities in valuation, earnings prospects and balance sheet quality at the stock level. ”
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