Chips falling into place for an Asian equity rally

By Steve Brice

Emerging Markets (EMs) are off to a flying start this year. Latin American and Eastern European stock markets are up more than 10% year-to-date, significantly outperforming their US and other Developed Market counterparts. However, Asian markets have lagged. There are increasing signs that the disconnect between Asia and other EMs may not last much longer.

We believe there are three major signposts to look out for an Asian equity market catch-up rally, some of which have started to flash green.

The primary building block for a recovery in EM assets following last year’s reversals was put in place by the US Federal Reserve at its December 2018 meeting. After pushing through 2ppts in interest rate hikes over a span of two years, the US central bank acknowledged that US financial conditions had tightened to a point where they could afford to be ‘patient’ and examine the impact on domestic economic activity.

A ‘patient’ Fed is good news for EMs and Asia because it halts the once-growing divergence in monetary policy between the Fed and the rest of the world. As US policy re-synchronises with the world, albeit temporarily, the US dollar is likely to reverse some of last year’s gains. A softer US dollar in turn enables EM financial conditions to loosen, while encouraging institutional investors to shift funds to EM assets.

We see early indications of this phenomenon – EM equity markets have so far seen the strongest fund inflows since the first two months of 2018. A prolonged Fed pause on rates, which is likely to hold well into the middle of the year given contained US inflation, could accelerate the flows and the EM equity rally. 

Asia is likely to particularly benefit from the renewed inflows if a second condition is met – namely, China steps up its support for its economy. Over the past few months, Beijing has not only shelved its plans to deleverage the economy and tighten environmental and other regulations (at least for now), it appears to have done a U-turn in policy and shifted focus to supporting growth. 

In gradual but increasingly orchestrated steps, China’s policymakers have cut bank reserve requirements, eased credit support for small and medium-sized companies, cut personal and corporate tax rates and eased rules for local governments to issue more bonds to finance infrastructure projects, while fast-tracking their regulatory approvals. While these measures are milder than the large investment-driven stimulus seen after the 2008 financial crisis, we believe they are likely to help stabilise growth in the coming months and aid a recovery by H2. 

China’s coordinated, growth-boosting measures are a key reason why China is our preferred equity market within Asia. Moreover, China’s onshore equity market is trading below its long-term average valuation of 11x 12-month forward earnings and is close to historical lows, making it attractive within Asia. Meanwhile, Asia ex-Japan valuations of around 12x 12-month forward earnings are also below their long-term average.

There is also an important distinction between China’s current policy measures and those in the past which has investment implications – the latest stimulus measures are mostly directed at boosting domestic consumption, whereas the investment-driven stimulus measures of the past benefitted global suppliers of key commodities, including several non-Asia EMs. Given this, the latest policies make China’s domestic-focussed consumer discretionary sector particularly attractive for investors. 

Lastly, any resolution, or even a thaw, in the ongoing US-China trade disputes would be a crucial building block for a sustainable rally in Asian equities this year. There are hopeful signs here. For one, there seems to be growing understanding in the US administration that a prolonged trade war might be damaging for the US economy itself. The slowdown in US growth in Q4 can be partly ascribed to the spillover of the global growth slowdown, sagging business confidence and tighter financial conditions. The US equity market volatility in December reinforced this concern.

Hence, we see the growing willingness among the two sides to avoid further escalation of the tit-for-tat tariff war and to reach a negotiated settlement. We believe one way forward would be for the two sides to separate their disputes over intellectual property from the broader trade imbalances. China has already pledged to boost imports of aircraft, automobiles, energy and agricultural commodities from the US in the coming years. These steps should help narrow the US-China trade gap over the coming decade.  

For sure, the challenges against a sustained revival in risk assets in EMs remain non-trivial. The global economic cycle is mature; the Fed may yet resume rate hikes as domestic labour markets continue to tighten; China’s high debt levels mean it faces structural impediments against significantly pump-priming growth; and the intellectual property disputes between China and the US may become more entrenched. These risks justify a broadly diversified approach to investing, with exposure to stocks, government and corporate bonds, gold and other alternative assets. Nevertheless, we see the stage being set for Asian equities to catch-up with other EMs and outperform global equities over the coming year. 

(The writer is Chief Investment Strategist at Standard Chartered Private Bank.)