Investing in Asia Pacific: a waiting game

A monthly guide to investing in Asia Pacific financial markets

Since the end of the 2Q earnings season, global equities have rebounded and 10-year US government bonds have sold off. Both moves were sparked by hopes that the US and China might reach an interim deal, and that stimulus might revive global growth.

The key question now is whether those hopes bear out. With both China and the US talking, there’s a chance that hard-hitting new tariffs to be implemented in the coming months will be delayed once again or perhaps even averted. But the gap between the two sides remains wide and even an interim deal in the weeks ahead is far from guaranteed.

Until greater clarity emerges, we remain cautious on taking too much risk.

And while in Asia governments have the scope to loosen the fiscal taps and pursue structural reforms, in developed markets already low rates and a limited willingness to grow deficits mean the chances of a meaningful boost to growth are low.

Until greater clarity emerges, we remain cautious on taking too much risk. Globally, we continue to prefer carry – via emerging market currencies, emerging market hard-currency bonds, and euro investment grade bonds – and stay underweight equities. Within Asia, we remain neutral on risk overall but take positions in certain currencies, prefer bonds over equities, and like quality value stocks with reliable dividend yields.

A waiting game on trade

We’ll find out soon whether President Trump will continue pressuring China by increasing tariffs over the coming months, or if he intends to strike a deal. In our view, if the US equity market and US growth remain stable, the risk of additional tariffs will likely remain elevated. Conversely, slowing growth may lead to de-escalation from both sides.

Since media reports about an interim deal surfaced, several questions have arisen about what such a deal might look like. The US could agree to delay future tariffs (planned for 15 October and 15 December 2019) and ease restrictions on Huawei. In exchange, China might make substantial purchases of US agricultural products and fast-track market access.

If an interim deal is reached, we believe USDCNY could fall to 7.0 and Asia ex-Japan price-to-book valuations could rise to 1.45x (from 1.42x currently). A more comprehensive deal, including a roll-back in tariffs, could see the pairing shift back into the 6.5–7.0 range and valuations climbing to 1.6x. A breakdown in negotiations, however, could prompt a sharp retracement of recent gains, pushing USDCNY up to 7.4 and regional valuations down toward 1.2x.

That said, it is important to remember that regardless of progress on an interim deal, the strategic rivalry between the two superpowers is deeply entrenched and will continue, in our view.

Crunch time for global growth

Geopolitical tensions have weighed heavily on business sentiment, producing a sharp deceleration in capex and manufacturing – the US ISM fell into contractionary territory in August, while Chinese industrial production growth has sunk to an all-time low of 4.4% and pricing power continues to deteriorate.

For next year, we now expect global growth to decline to 3.0% (from 3.4% without the tariffs) and China’s GDP expansion to slow to 5.5% (previously 5.8%). And while the US should slow further, a recession is not our base case. Timing-wise, we expect the region to lose steam further into the year-end, with a sharp loss of momentum in 1H20.

Even an interim deal, at this stage, would not prevent the slowdown – although it could limit the drop in Chinese and US economic growth we expect for 1H20. Specifically, we think a deal could permit 5.8%–6.0% Chinese GDP growth next year. The good news is that, as we enter this slowdown, the degree of excess capacity and inventories in Asia is much less than on previous occasions and China has ample policy bandwidth left to support growth (e.g., through tax cuts, expanded local government bond issuance, and lowering the MLF rate). We also expect further monetary easing from central banks around the world – we expect the Fed to ease policy further if needed this year and next and forecast 25–75bps of cuts in Asia by end-2020, with the risks being skewed to sooner rather than later.

The recent strike on Saudi Arabian oil facilities is an additional downside risk to consider. Parts of Asia remain highly sensitive to longer-term oil supply disruptions; a sustained USD 10/bbl rise in Brent crude prices (e.g., USD 60/bbl to USD 70/bbl) could lower regional earnings growth by 2ppt over six months.

Asia TAA: Adding optionality

This month we make some adjustments to our Asia FX positions, and add a low-cost option strategy on the Taiwan stock market (Taiex) to reflect the highly uncertain nature of upcoming trade talks. To capture potential upside from a truce/interim trade deal, we add a long 5% out-of-the-money call on the Taiex index. And to protect the downside from a negotiation breakdown, we add a long 10% out-of-the-money put option on the same index. We also take profit on our long Indonesia rupiah vs. Philippine peso position, and add a long Korean won vs. US dollar trade.

In our global asset allocation, we remain underweight equities overall and add an underweight in the Australian dollar vs. the US dollar within our FX strategy.

Within equities, we prefer US stocks, which are better placed than Eurozone equities in this environment of heightened risk and growth uncertainty. Within international developed stocks, we also maintain our preference for Japanese equities over Eurozone equities. In Asia, we remain overweight Mainland China and Malaysia as well as underweight Hong Kong and Thailand.

Asset classes

Equities

• Asia ex-Japan equities are up by low single digits in September despite mixed 2Q regional earnings, which were affected by trade-related weakness. As a whole, the region has benefited from the global reversal of momentum trades and sector/style rotation. Prior to this rotation, the valuations of APAC value stocks were close to financial crisis lows (0.98x P/B) and their discount to growth stocks at a 15-year high.
• For many value stocks in APAC, valuations have been suppressed by structural concerns. But we see opportunities in high-quality names even after the recent rally. Moreover, we continue to like safe dividend yielders and stocks with exposure to secular growth like internet names and beneficiaries of smart city development. In Hong Kong, we like select conglomerate and infrastructure stocks that have been unduly beaten down due geopolitical issues and are trading close to five-year lows.

Credit

• After a difficult August, JACI high yield (HY) spreads have narrowed in September by roughly 8bps, with returns positive (+0.5%) due to the better risk environment. And, while JACI investment grade (IG) spreads have also tightened by a modest 4bps, the sell-off in US Treasuries has caused performance to fall 0.2% this month. We maintain our preference for select exposure to the HY segment, favoring higher-rated Chinese property issuers (BBB/BB). We would avoid longer-dated single B bonds.

FX

• APAC currencies gained ground in September as hopes of an interim trade deal appeared. As mentioned, an interim trade deal could see USDCNY at 7.0 and a comprehensive one could bring USDCNY to 6.5–7.0. We also maintain our preference for higher-yielding currencies regionally, such as the Indonesian rupiah and the Indian rupee.

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Written with Mark Haefele, our Chief Investment Officer.

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