Down but not out in Asia

A focus on high-quality companies is critical to capturing value in Asia, says Flavia Cheong, Head of Asia Pacific ex-Japan Equities, Aberdeen Standard Investments.

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What a difference a year makes. This time last year I wrote: “Asia is sitting pretty. Things haven’t looked this good in years”. With hindsight, I may have been guilty of some hubris.

But in my defence, the outlook at the start of 2018 did look bright.

Following a blockbuster 2017 for markets, there were expectations of synchronised growth in the global economy and corporate profits. Analysts were forecasting the US dollar to weaken amid benign inflation. Liquidity was abundant. The reality was very different. The MSCI Asia Pacific ex-Japan suffered its worst year since 2011, falling by some 14% in US dollar terms. Almost all markets and sectors sank lower. So what went wrong?

US hikes rates

The US economy maintained its brisk growth last year, fuelled by President Donald Trump’s tax cuts. This coupled with the desire of policymakers to normalise monetary policy led the Federal Reserve to raise interest rates. Higher US rates are usually bad for emerging markets.

The Fed’s four hikes boosted the US dollar, along with demand for safe-haven assets driven by currency crises in some emerging markets. This sucked capital out of emerging markets, including Asia. In response, most Asian central banks raised interest rates to protect their own currencies and combat inflation. Unfortunately, higher rates can also be an obstacle to economic growth.

US-China trade war

Another big factor weighing on Asia was of course, the trade war between the US and China as each country objected to tariffs imposed by the other. As US-China tensions worsened, investors worried about the likely impact on economic growth and corporate profits. This dragged on Chinese markets, along with those in Korea and Taiwan.

President Trump and Chinese leader Xi Jinping have agreed a temporary truce, but we’re sceptical of a resolution given the complexity of the issues and limited time in which to find a solution. We aim to invest in Chinese companies that depend on domestic demand, rather than overseas trade and exports. However, should tensions escalate again, even this more insulated part of the market won’t be spared.

Slowing China

Chinese growth was already slowing even before US-China trade ties soured. Policymakers had been trying to reduce the amount of debt that had built up since the global financial crisis. But as trade frictions escalated, the government partially reversed course. It cut taxes, lowered banks’ required reserve ratio, and increased infrastructure spending once again.

This policy relaxation helped to support the economy. For example, the property sector benefited when local governments were given more leeway to tweak restrictive policies. But in the long run, policymakers want more sustainable growth, rather than growth-at-all-costs. This is a structural shift that means slower growth is here to stay.

Poor tech sentiment

Technology stocks were the stars of 2017, but lost steam in 2018. Trade tensions weighed on consumer sentiment, hurting demand for smartphones and memory chips. This hampered shares of semiconductor and hardware-related companies, including Samsung Electronics.

Meanwhile, regulatory issues plagued Chinese internet firms such as Tencent. While these issues hurt its gaming revenues, we are confident that other revenue streams, such as payments and cloud-services, will continue to grow. There are also signs of easing regulatory pressures.

Looking ahead – end of QE

This year promises to be just as eventful as 2018. The era of quantitative easing (QE) is ending as central bankers around the world seek to roll back the emergency stimulus measures that have helped the global economy recover from the global financial crisis of more than a decade ago.

The withdrawal of QE, with the Federal Reserve in the vanguard, will raise the cost of capital. Under normal circumstances, higher interest rates impede economic growth and undermine investor sentiment in equity markets. However, we have been arguing for some time that ending stimulus is a good thing because years of cheap money had indiscriminately boosted asset prices and created market distortions. We don’t know how this unwinding process will end, but it’s clear to us that doing nothing isn’t an option.

Politics take centre stage

Politics will be important too. While US-China trade tensions are often framed as an economic issue, what lies at the heart of the matter is geo-political. My colleague Devan Kaloo recently wrote about this in a letter to clients. “There has been a strategic shift in Washington’s attitude towards Beijing, moving from one of containment to confrontation,” he observed, “The US identifies China as a strategic rival, similar to how it viewed the former Soviet Union”.

“This potentially has longer-term implications for global capital flows, manufacturing supply chains and geopolitical alliances, as countries are increasingly pressed to take sides”.

This is a structural issue that will play out over years, if not decades. However, in the coming months, there will also be major elections in India and Indonesia. The outcome of those polls could decide whether economic and market reforms in those countries will proceed unimpeded. Thai voters are also scheduled to cast their ballots in general elections this year, although several recent attempts to elect a new government were cancelled.

Our response

On many fronts, financial markets are entering uncharted territory – and increased uncertainty often leads to greater volatility.

We started tweaking our Asia Pacific ex-Japan portfolios a couple of years ago, partly in recognition of these changes in the investment landscape. We pared our exposure to Singapore and Hong Kong in favour of markets with more attractive growth potential, such as China and south-east Asia. We also rebalanced our positioning towards the financial and technology sectors because of long-term structural trends we had identified. These changes, coupled with our continued focus on high-quality businesses, helped buffer our investments against last year’s big market declines.

Focusing on ESG

In addition, we continue to invest much time and effort into corporate engagement on environmental, social and governance (ESG) matters. There’s a temptation to dismiss ESG as a fad for touchy-feely do-gooders. But ESG analysis isn’t simply driven by the desire to do the right thing. There is evidence of a link between good management of ESG risks and good management of the financial risks that determine corporate performance.

That’s why, for example, we wrote to all our investments listed on China’s two onshore stock exchanges in the so-called ‘A-share’ market. Our holdings in this market number more than 30 and we were encouraged by their response to our urgings for further improvements in corporate disclosure.

Staying selective

Challenging times lie ahead. Nevertheless, profit forecasts for many of our holdings are still decent, despite more cautious guidance. Lower energy prices should help ease cost pressures and improve margins. Although we are seeing substantial value emerging following 2018’s sell-offs, we still need to be selective.

Needless to say, we continue to focus on stocks with solid balance sheets, stable cash flows and pricing power. We think such companies will have the right stuff to withstand uncertainty.

Aberdeen Standard Investments’ Asian investment companies

Aberdeen Standard Investments manages seven investment companies in the Asia-Pacific region:

Important information

Aberdeen Standard Investments is a brand of the investment businesses of Aberdeen Asset Management and Standard Life Investments.

Risk factors you should consider prior to investing:

  • The value of investments and the income from them can fall and investors may get back less than the amount invested.
  • Past performance is not a guide to future results.
  • Investment in the Company may not be appropriate for investors who plan to withdraw their money within 5 years.
  • The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the Net Asset Value (NAV) meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
  • The Company may accumulate investment positions which represent more than normal trading volumes which may make it difficult to realise investments and may lead to volatility in the market price of the Company’s shares.
  • Movements in exchange rates will impact on both the level of income received and the capital value of your investment.
  • There is no guarantee that the market price of the Company’s shares will fully reflect their underlying Net Asset Value.
  • As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices, the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
  • The Company invests in emerging markets which tend to be more volatile than mature markets and the value of your investment could move sharply up or down.
  • Specialist funds which invest in small markets or sectors of industry are likely to be more volatile than more diversified trusts.
  • Yields are estimated figures and may fluctuate, there are no guarantees that future dividends will match or exceed historic dividends and certain investors may be subject to further tax on dividends.

Other important information:

Issued by Aberdeen Asset Managers Limited which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.

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