The successful implementation of reform is crucial to the full realisation of Asia’s growth potential, but progress is far from uniform. Andrew Swan, Head of Asian Equities, reveals what this means for his portfolios.
Looking back over the first four months of this year, one thing is clear in Asia – where reforms have progressed and liquidity improved so flows and performance have followed. In the Chinese Year of the Goat, animal spirits are back:
Korea has long been regarded as a cheap, low quality and cyclical market prone to earnings disappointments and corporate governance let downs. But, as one of Asia’s better performers this year, it’s finally showing signs of realising the value we’ve seen for a while now.
Financial conditions are easing and reform is coming through, with rate cuts and housing deregulation unleashing a flood of domestic liquidity into the market. Add in some much needed weakness in the won, and valuations (among some of the key cyclicals) at lows last seen in the aftermath of the Global Financial Crisis, and the scale of the opportunity is apparent.
We hold a mix of growth companies, IT stocks with visible demand and cheaper value cyclicals. Year-to-date, some of our better performers have emerged from Korea – notably LG Household & Healthcare and Hyundai Engineering & Construction – allowing us to deliver +2.0% alpha. But many of our competitors, with their longstanding bias towards quality, have very limited exposure to Korea, which is increasing the pressure on their performance. Positive earnings revisions will be needed in order to sustain the rally. Should the outlook for global growth stabilise, there are clear opportunities to generate alpha in sectors that can offer consistent earnings delivery and profit turnaround.
The Reserve Bank of India (RBI) accepted its latest invitation to join the global easing party in March, by cutting its repo rate by 25 basis points to 7.5%, and by another 25 bps in June, following signs of slower than expected growth.
Inflation, so long a scourge of the economy, has also taken a helpful tumble in the wake of collapsing oil prices.
The announcement was a surprise, which isn’t necessarily a bad thing – there’s a long-held belief that rate cuts in India need the element of surprise in order to have the desired effect. It reaffirms our view that monetary policy is in good hands under Governor Raghuram Rajan, formerly of the IMF, who is showing a decisiveness and independence often lacking in his predecessors. Indeed, the RBI is finally starting to resemble a modern central bank, with an official inflation target and an explicit, streamlined mandate of maintaining price stability and supporting growth.
We remain overweight India because growth is poised to recover and inflation is falling. While growth is not recovering as quickly as initial expectations (fiscal spending has been constrained to meet government targets) the long-term growth recovery looks intact. This will be good for profits and ensure that, despite higher starting valuations, we can still expect good returns. Our preference is for those stocks most exposed to a revival in economic momentum and business investment. We are therefore tilted towards value and risk, whether through power-related stocks or additions to our holdings in Financials.
China’s A-share market has doubled over the last 12 months, helped by three PBOC rate cuts in the last six months, while H-shares touched seven-year highs in April on speculation that reform could help the market catch up with its mainland counterpart. Of course, that’s made many investors question whether this particular rally still has legs.
We believe it does, provided structural reforms continue to progress. For example, the recent expansion of the Shanghai-Hong Kong Stock Connect scheme prompted huge flows into Hong Kong, especially where H shares were trading at large discounts to their A share equivalents. Capital market reform is proceeding much quicker than expected and while near-term growth is likely to be tepid, falling risk premia and abundant liquidity are powerful catalysts for performance.
The other key question is how to play this rally. A share valuations may be some way off historical peaks, but
turnover is as high as it’s ever been, with retail investors particularly active. Risks are rising at a time when valuations are diverging from underlying fundamentals and the market appears to be trading on liquidity. But it’s no longer a question of turning to H shares instead, with the pricing gap between the two markets having narrowed sharply.
The MSCI has confirmed that A shares will be included in its global benchmarks, with some initial inclusions possible in the next 6-12 months. That said, full inclusions will likely be more than three years away so in short the news hasn’t changed our views. We remain relatively cautious on A shares given the extent of the recent market rally and extreme valuation stretch. In H shares, we still see some value in mid-cap banks, property, utilities and new energy, but areas like construction, capital goods, transport and energy have become less attractive. Selectivity will be vital; whether choosing between companies, sectors or A and H share opportunities.
Unlike many of our competitors, especially those with a quality bias, we remain overweight China, although we have reduced our exposure (notably to momentum).
Where the path to reform has been less smooth, performance has been much weaker. Take Indonesia, where President Joko Widodo is yet to convince investors he has the toughness, or the necessary mandate, to implement key reforms. His PDI-P party holds only 20% of the seats in parliament, which has made his task much harder. Contrast this with India, where despite some setbacks we are confident Narendra Modi has the mandate to implement his reforms.
Indonesia is experiencing its slowest growth in more than five years and, having been disappointed by the last corporate earnings season, investors are desperately looking for signs the president can push through infrastructure projects to better connect the islands and create a more investor-friendly business environment.
Without such progress, the future looks challenging for an economy with millions on the breadline and a market that’s heavily exposed to low commodity prices and rising US rates – a scenario that’s unlikely to change any time soon.
Malaysia has also struggled to match the progress seen in China and India. Prime Minister Najib Razak’s administration is becoming increasingly authoritarian, which risks unravelling the country’s delicate ethnic and political balance and could stall any progress on reform.
As a significant exporter of oil, Malaysia is also vulnerable to the kind of sharp oil price declines we saw earlier this year, yet its valuations are still high. We see no reason to revise our underweight position.
Overall, more positive signs are emerging in Asia, but the effective implementation of reform remains the crucial ingredient for stronger performance. Markets like China A and H shares have already delivered incredible returns in a relatively short period of time.
The search for alpha has become more demanding. One theme is constant throughout – style biases could hinder returns and flexibility is more vital than ever.
Only 56% of Asia ex Japan managers have outperformed their benchmark so far this year*. Our consistent alpha
generation over the past three years shows that a flexible, pragmatic and forward-looking approach can prosper even in the most challenging periods.
* Source: Bloomberg, FactSet, Goldman Sachs Global Investment Research, as at May 2015.
Source: BlackRock, as at May 2015.
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|Hang Seng Index||24,345.87||152.17|
|South Korea KOSPI||2,163.31||7.65|
|Dow Jones Index||20,550.98||-45.74|
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