Inclusion of A-shares in China
The macro environment and the inclusion of A-shares in the MSCI Emerging Markets Index is set to boost optimistic investor sentiment towards the Chinese market, with innovation-related sectors acting as a catalyst for China’s growth over the next decade
Investor sentiment regarding the Chinese equity market is expected to improve in the second half of 2017 given the inclusion of China’s A-shares into the MSCI Emerging Markets Index, coupled with a continuously stable macroeconomic environment. Meanwhile, growth in China’s equity market over the next decade is expected to be driven by innovation.
Growth momentum remains robust from the beginning of 2017, backed by 6.9% GDP growth in the first quarter, which is better than expected and is the strongest quarterly real GDP growth since the third quarter of 2015. Inflation remains stable and monetary policy remains accommodative, which bodes well for steady economic progress. In addition, continued strong infrastructure investment continues to boost the manufacturing sector, which provides fundamental support to the market.
The fundamentals of China’s economy are positive for the long term, which supports investment sentiment in the market. In addition, the inclusion of Chinese A-shares in the MSCI Emerging Markets Index marks another milestone of the internationalisation of Chinese equities. The Chinese capital market will become more attractive for global asset managers (both equities and bonds) and there will be more investments in China’s onshore market.
Though the pace of reforms, non-performing loans and the volatility of the Renminbi are risks that investors have to consider, we expect innovation to be a catalyst for long-term growth over the coming decade. If we examine China’s economy from a bottom-up perspective, innovation has been a major theme driving the economy, especially with respect to big data, cloud technology and artificial intelligence. Investors should also keep an eye on China’s long-term strengths derived from its demographics. The abundant supply of college graduates will drive a rapid and robust development of innovative products and services, which will encourage China’s transformation from ‘the world’s factory’ towards an ‘innovation hub’. There are promising prospects for companies with outstanding innovative capabilities and products across the consumer-related, services and industrial sectors, which will drive growth over the next decade.
In a low interest world, does Japan benefit?
From bonds to equities to infrastructure to real estate, all assets around the world are looking expensive. However, this isn’t due to strong economic growth over the past five years but instead, extremely low interest rates. Accommodate monetary policies have seen investors search for yield: to take more risk than normal to achieve returns that were more readily available when interest rates were higher. Ultimately, that behaviour stems from requiring returns that at least keep up with inflation.
The indefinite continuation of these ultra-low monetary policies when inflation is meaningfully positive could therefore cause an asset price bubble. Whilst not forecasting an event like this to occur, it certainly is a large concern for financial markets. Countries where the interest rate sits persistently below the inflation rate are the most exposed to this risk because savers in these economies could experience the biggest reduction in purchasing power, and hence search for more yield. For this reason, we don’t believe all zero interest rate policies are equal - take for example Japan: perennially low inflation means the Bank of Japan's zero interest rate policy is good in the sense that it hasn't impacted Japanese purchasing power. With inflation much higher in the West, the same monetary policies could be classified as somewhat negative as they have reduced purchasing power. Several Japanese investors have become realistic in downwardly adjusting their return expectations and their risk taking has remained sensible. This represents an important acknowledgement of the new normal, which investors around the rest of the world, still haven’t addressed.
Whilst there are still risks relating to investing in Japanese equities - of note, the structural problems the country face, can’t be ignored, these structural issues are driving markets at the moment - it’s the search for yield that is spurring investors to increase their exposure to risk assets. As such, Japanese equities could prove to be defensive in a downturn.
Within Japan, the sectors that we think look attractive given they could provide new investment avenues are IT and consumer-related. With an ageing population and shrinking labour force, automation is likely to gain prominence. IT spending in the small & medium enterprise space is lagging behind large corporates, and has the potential to rise in the phase of industrial automation. In the consumer space, there are segments that can benefit from the demand of products required by an ageing population. Innovation and premiumisation of certain product categories, especially baby care and cosmetics, are likely to provide investment opportunities. Furthermore, corporate governance is improving and tax reforms are expected to encourage more efficient management and organisational structures through spin-offs.
Artificial Intelligence (AI) and associated investment implications
AI is aimed at overhauling key computing engines to bring the digital world closer to the real world. The availability of training data and deep learning (a subfield of machine learning which uses multi-layer artificial neural networks) is crucial for the development of AI. Notably, ownership of data is the key as AI algorithms/rules will become commoditised over the time. Asian players may have an edge over western counterparts as privacy laws are much more lax in Asia. For example, China’s Baidu, Tencent and Alibaba are investing in this space, with Alibaba having facial data of 480 million Chinese users, while Tencent has a large user base on its mobile platform Wechat.
AI is key component for autonomous cars. These cars require vision, maps and understanding of their surroundings for AI to drive vehicles. From a technology perspective, semiconductors, particularly sensors, processors and actuators, benefit with the move towards autonomous driving. Sensors and processors are key areas with more market disruption and higher future application is likely in the latter. Demand for semiconductors and camera lens with high resolution is expected to get a boost, even as map providers are crucial. Autonomous cars are likely to reduce accidents, which is negative for the automobile insurance market. Nonetheless, more efficient driving conditions are expected to be positive for overall automobile demand.
AI is expected to foster automation in manufacturing. In factory automation, robots can get smarter with machine vision and even smarter with AI. Industrial IoT, i.e. through connected machines, is expected to help in digitising operations. IoT and factory automation are required to work together for AI’s success. IoT value chain shows a variety of players that can benefit from factory automation; nonetheless, AI will be able to provide the most value in the platform and applications layers. While IBM, Microsoft and SAP are believed to be best placed in IoT platform space, Siemens, Fanuc and Rockwell have good chance of being winners. Routine jobs have been stagnating for a while as traditional automation software/robots have managed to replace them. End markets for industrial automation so far has been concentrated, primarily automotive and electronics. We are now at inflection point which opens up other industries such as food & beverage, warehousing and retail for automation as cost of automation is declining and emerging market low cost providers are facing wage pressures. Technical breakthroughs will also expand the utility of robots in automation.
AI and deep learning have been enhancing voice and messaging interfaces. Speech recognition requires a machine to understand not just accent, but also context and meaning, and pauses and pace. Errors in speech recognition started reducing materially and accuracy improved with the application of deep learning techniques. This is likely to lead to proliferation of messaging bots and virtual assistants such as Google Assistant and Amazon Echo/Alexa across various consumer segments. In China, iFlyTek & Baidu lead in the voice recognition segment whilst Tencent and Alibaba have the potential to launch new products with a much stronger ecosystem.
Finally, AI coupled with augmented reality (AR) has the potential to boost efficiency in health care. Data from various parts of healthcare eco-systems can be consolidated and analysed to assist in learning, visualise various stages of diseases, and suggest treatments and project success.
India’s GST likely to be a game changer for future Indian growth
On 1 July 2017, India rolled out its ambition tax reform called the Goods and Services Tax (GST). The GST aims to economically unify the country under a single nation-wide indirect tax system. Up until now, each of the country’s 29 states and 7 union territories were imposing their own set of taxes and levies. The new tax regime is expected to reduce inefficiencies, improve tax compliance and expand the country’s tax base over the long term. A reform of such large scale is unprecedented for India and is expected to create short term disruptions, but it reflects the government’s positive intent and its ability to take bold policy decisions.
Potential near term disruptions
Given its scale, economic disruptions are expected in the next one to two quarters. Our channel checks suggest destocking of inventories by distributors and wholesales and potential contraction in the unorganised sector. However, long term benefits and efficiency gains outweigh near term pressures. We have already seen countries such as Australia and Malaysia successfully implement similar goods and services tax systems in the past.
In a nutshell, we think a change of this scale in India is unprecedented and demonstrates the government’s commitment to reforms and its willingness take bold policy decisions. The country currently has a plethora of state level indirect taxes that make doing business in India just like doing business in 29 different countries. With GST, these different taxes get subsumed into a single tax system for the country. While GST may create some disruptions over the next one to two quarters, it will help reduce logistic costs, enhance ease of doing business, simplify the way taxation is administered and increase the tax base of the country over the long term. Note that India’s tax to GDP ratio of 17% is much lower than the emerging market average of 21% and the OECD average of 34%.
