Asia 2Q Outlook: Turning points - Investing in Asia Pacific (March edition)

A monthly guide to investing in Asia Pacific financial markets

Asia is feeling the effects of the Ukraine war. High commodity prices, in addition to rising US interest rates, are pressuring the region’s markets and economies. Macroeconomic dynamics have worsened across the board, with energy importers and interest-rate-sensitive economies the most vulnerable to these risks.

But while the downside scenarios loom large, valuations are trading at low historical levels and earnings per share for Asia ex-Japan should grow by around 10% in 2022. We advise investors to focus on beaten-down quality names and beneficiaries of policy easing in China and reopening in Asia.

Volatility will no doubt remain elevated in the weeks and months to come, presenting an opportunity for investors to gain long-term exposure, potentially at a discount. Here, we think leading Chinese ADRs are attractive for their low valuations, still-solid earnings growth potential, and buyback prospects. In general, investors should look to quality stocks with strong return on equity and free cash flows.

Particularly noteworthy is that policy news in China is finally looking more upbeat. China’s pledges to support economic growth and markets may mark a turning point for investors. Beijing’s pivot has eased panic over slowing growth, property credit issues, and new economy regulations. The government’s move to relax some pandemic controls suggests a less restrictive stance in the future, while recent comments from Beijing have lifted hopes that China is seeking to avoid sanctions that could result from enhanced ties to Russia.

Fueled by stimulus measures, we expect China’s economy to soon bottom and rebound over the course of 2H22, growing by over 5% for the full year, with fiscal policy doing the heavy lifting. Credit growth is set to pick up in the quarters ahead, the lockdowns should have a relatively limited overall impact, and a weaker yuan should help exporters. So, we keep Chinese equities at most preferred regionally.

We prefer cyclicals and value stocks for tactical positioning, including the energy, metal and mining, and construction material sectors, as well as select telecom names. Further out, intelligent infrastructure and cybersecurity should benefit from an increased focus on tech self-sufficiency and spending.

This month, we are lifting Asia investment grade debt to neutral, as its spread no longer looks expensive and we are more constructive on its return prospects. Asia high yield debt, on the other hand, will likely face turbulence in the near term from default headlines. But as property policies are easing—mortgage rates are falling in over 100 cities—Chinese HY bonds should find support in 2H22.

The war in Ukraine and the Federal Reserve’s hawkish stance are going to keep markets choppy for some time. But Asia’s reopening and China’s policy tailwinds should present opportunities for patient investors who can withstand bouts of volatility.

Written with?Mark Haefele, our Chief Investment Officer.

How should investors position amid the uncertainty?

Authors: Sundeep Gantori, Devinda Paranathanthri, Crystal Zhao, Hartmut Issel, Delwin Kurnia Limas, Dominic Schnider, Wayne Gordon

After a challenging 2021, Asia ex-Japan markets had a strong start to 2022. But the good mood reversed quickly upon the Federal Reserve’s hawkish pivot, driven by a stickier inflation outlook; fresh regulatory and ADR delisting concerns in China; and Russia’s invasion of Ukraine. Sentiment remains cautious and uncertainty is still elevated, making it imperative that investors diversify across regions and asset classes and implement portfolio protection.

It’s turbulent times, but we see opportunities to gain exposure to near-term trends and longer-term themes. We also recommend select hedges, such as commodities and hedge funds, in case the headwinds grow stronger, as well as focusing on quality given the choppy waters.

Focus on quality in equities

Even after the recent rally in China, the MSCI Asia ex-Japan benchmark is now down 9% year-to-date and its price-tobook (P/B) valuation is still 10% below its historical average. Still, we’re neutral on the region’s equities overall in view of the challenging environment and potential risk cases.

As volatility will stay elevated in the near term amid the geopolitical and rates backdrop, we recommend long-term investors to focus on quality stocks with sustainable return on equity and strong free cash flow generation. Rising cash distributions, which includes higher dividend payouts and share buybacks (particularly in China), could act as an additional catalyst. Most of these companies are in the financials, consumer, communication services, and technology sectors.

Reopening trade outperformance to continue

With reopening accelerating across Asia, we continue to recommend our reopening/reflation basket. Asia is taking steps to treat the pandemic as endemic, and even China is tweaking its containment strategy. The theme is up 4% this year, outperforming the region by 13 percentage points, and we see more upside ahead.

Key reasons to maintain this trade are: 1) solid earnings growth (2020–23 CAGR ~26%) at reasonable valuations, 2) policy easing in China should benefit capital goods and construction materials sectors, 3) higher-for-longer commodity prices should support metals and energy, and 4) central bank tightening and higher rates are supportive of banks. We’re especially constructive on energy, commodity producers, industrials, and financials in Japan and Singapore.

Cheap tech and structural opportunities

Asia’s major tech stocks are still trading at a 30–40% discount to global peers on a P/E basis. This offers investors the opportunity to gain exposure to beneficiaries of structural trends potentially at a discount, including “ABC” (artificial intelligence, big data, cybersecurity) leaders in Asia, subscription champions, players in the 5G supply chain, and drivers of Asia’s new economy.

As we mentioned in the previous pages, we think the top Chinese ADRs are trading at attractive valuations for their solid earnings prospects. Also, we see select longer-term beneficiaries from the rise of “silicon nationalism,” particularly within the 5G space and semiconductor supply chain companies in Asia.

Asia credit – quality IG names preferred

Asia credit returns continue to be challenged on the back of higher rates and woes in the property sector. But investment grade bond (IG) valuations on a historical basis are less expensive now with spreads well above historical averages and the index yield at 4.2%. While rates volatility could stay with us for longer because of the hawkish Fed, this correction could provide long-term investors with an opportunity to pick up quality names that are unlikely to face default risk, particularly in the IG space; we like names that offer 4% yield for less than five-year duration.

Elsewhere, within the bank sub debt space, we see value in select Tier 2 and AT1 bonds that have corrected in the past month. We remain very selective on high yield bonds and would focus on select non-property names in China and commodity players. We would avoid bottom-fishing in the China property sector for now until we see signs of sales recovery.

Asia FX – reopening currencies favored

Asian currencies are facing three headwinds: 1) higher US rates, 2) higher import costs (commodity related) and 3) slowing global growth (export concerns). While higher US rates are largely priced, deteriorating balance-of-payment (BoP) flows are worth tracking. The performance fault line within APAC currencies is likely to be set by commodity prices and the degree of slower economic activity. Also, more stimulus in China might weaken CNY but be supportive of APAC currencies overall.

We favor currencies linked to commodities and reopening themes, including the AUD, NZD, MYR, and IDR. We would avoid currencies with weak current account positions and those that are vulnerable to higher oil prices, such as the INR and PHP. Our preferred trades are long AUD versus other G10 currencies and long USDINR.

Using commodities to hedge the risks

With commodity prices set to rise in the months ahead, we recommend being long commodities via an active investment strategy. Besides gaining exposure to further commodity price upside, such a tactical position should be seen as an insurance position if commodity supply chains get further disrupted across different sectors.

Within the asset class, we are bullish on base metals. Falling inventories, risks to supply and a solid demand backdrop for metals linked to global decarbonization efforts favor higher metal prices overall. For the asset class, we target a total return in the high-single-digits over the next six months, which is needed to help balance the respective markets.

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