Investing in Asia Pacific: Green shoots

Fortune certainly favored the brave in the first quarter.

Our overweight on regional and global risk assets at the start of the year was rewarded with a near 15% gain in Asia ex-Japan (AxJ) equity markets, a 22% recovery in China, and a 16% rally in the S&P 500, which is its best start to a calendar year since 1998. Markets were supported by reduced US-China trade tensions, the Federal Reserve’s dovish tilt, and Beijing’s determined easing efforts.

The region’s revival has been faster and stronger than we expected. Green shoots emerged in Chinese credit and fixed-asset investment data for the first quarter, China’s PMIs returned to expansionary territory in March, and the robustness of China’s turnaround suggests scope for consensus GDP and earnings upgrades in the months ahead. Data has also started to improve in Korea, Taiwan, and Vietnam, led by a semiconductor rebound and solid exports. And outside Asia, US jobless claims have fallen to their lowest level since 1996, Eurozone industrial production has shown signs of life (albeit not yet in Germany), and the Brexit deadline extension to 31 October has reduced the imminent risk of a “no-deal” disruption.

The region’s revival has been faster and stronger than we expected.

Importantly, Asia’s long earnings downgrade cycle looks to be coming to an end and lower US Treasury yields and easing financial conditions should also be supportive of regional markets. That said, a strong profit upgrade cycle, like in 2016–17, seems unlikely at this point. And with GDP growth slowing globally – the IMF recently cut its estimate to 3.3% for 2019 from 3.5% – the rebound in trade regionally will likely only be moderate.

We’re recommending that investors Plan, Protect, and Grow to prepare for the months ahead.

Volatility cannot be discounted following the sharp 1Q rally, so we “protect” by holding put options in our global portfolio and a collar option in our Asia strategy. And we position to “grow” amid the regional economic recovery by remaining moderately risk on.

Don’t overhype the yield curve inversion

We think concerns about the US yield curve’s recent inversion signaling an impending market downturn may be misplaced for two reasons. First, today’s macroeconomic imbalances look benign compared to previous inversions (in 1989, 2000, and 2006), which were associated with rapid private sector credit growth and inflationary pressures. This makes this inversion potentially less meaningful.

Second, yield curve inversions tend to occur far in advance of a market peak. History suggests Asian equities peak on average only around 17 months after an inversion. And in the meantime, performance has ranged between +30% and +140% with cyclicals and large caps outperforming defensives and small/mid-caps. But volatility does tend to be higher after an inversion, so investors should consider protecting against downside risks.

Growth is stabilizing

Incoming data from China signals policy easing is strengthening the economy (we have upgraded 2019 GDP growth to 6.4% from 6.1%), and the rising likelihood of a US-China trade deal should boost consumer and business sentiment. A deal would also buy businesses more time to undertake planned adjustments to their supply chains.

A recent UBS Evidence Lab survey shows industrial migration – from North Asia to Southeast Asia – will continue irrespective of the trade outcome as firms seek to hedge future political risk and to manage costs.

Improved semiconductor activity and better order-to-inventory ratios point towards a recovery of growth in 2Q and a turnaround in industrial production. Asian exports are already rebounding: Korea, Taiwan, and Vietnam reported big gains in exports in March, led by shipments to China. And dovish monetary policy should encourage consumer spending in 2H; we expect interest rate cuts in India, Indonesia, and the Philippines, and expect China to maintain a pro-growth policy stance notwithstanding stronger-than-expected 1Q numbers.

That said, we expect capex spending to remain subdued, and tepid US and German new manufacturing orders bear watching given their effect on inventories and pricing power in Asia.

So, has the market run too far ahead? We think not, and believe that earnings, which hold the key to the next leg up, are likely to improve alongside macro conditions.

Asia TAA: Adding cyclicality

So, has the market run too far ahead? We think not, and believe that earnings, which hold the key to the next leg up, are likely to improve alongside macro conditions. Hence, we remain overweight MSCI AxJ versus US IG bonds. Within equities, in addition to our overweights on China and Singapore, we add cyclicality by shifting Taiwan to overweight, turn underweight on Thailand, and maintain our underweights on Malaysia and Hong Kong. We also overweight Japan (versus the Eurozone) in our global tactical asset allocation.

And in currencies, to take advantage of the Fed’s dovish pivot, we open a long Indonesia rupiah versus Philippine peso position, which comes with an attractive 300bps carry. We remain long the Singapore dollar versus the Thai baht.

Equities

The recent 4Q earnings season was weak, with just one third of Asian companies beating expectations. Korea, Taiwan, and Thailand mostly disappointed, but Hong Kong and Indonesia fared better. Meanwhile, signs of stabilization are emerging in China’s producer prices and dynamics in the region’s IT sector are turning up. As the earnings downgrade cycle inflects, we expect modest upside for stocks for the rest of the year. The region now trades at a price-to-book valuation of 1.57x, just below the 10-year mean (1.60x).

Against this backdrop of modest earnings growth and subdued interest rates, we think growth and yield stocks should perform best in Asia. We prefer large caps over mid- and small caps, and select tech and insurance leaders. We also see opportunity in companies exposed to structural growth in China’s Greater Bay Area, and those supporting the development of smart cities in the region.

Credit

Asia high yield (HY) has continued its strong performance, taking its year-to-date return to 8.0%, outperforming Asia investment grade (IG) (3.9%). Dovish central banks, China’s easing policy, the improving macro picture, and strong emerging market debt inflows have driven the rally. We have updated our full-year return expectations for HY to 11–12% and IG to 5–6% to account for the year-to-date performance and coupon carry.

That said, technicals will likely be tested in the coming months as issuance picks up. With HY spreads now below 500bps and the differential between BB and B spreads below the 5-year average, we believe valuations have little room to compress further. We also expect some pick-up in spread volatility in 2H.

We prefer good-quality BB and B Chinese property bond issues with improving credit stories, perpetuals with higher step-up coupons, and select BBB rate issuers.

FX

Asia-Pacific currencies have climbed almost 1% versus the US dollar on average this year. Within the region, we expect the Indonesian rupiah and the Indian rupee to deliver the best total returns over the next 12 months – both currencies yield about 5% relative to the USD. We anticipate USDCNY to trade in a stable range of 6.5–6.8 for the rest of the year.

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Written with Mark Haefele, our Chief Investment Officer.

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