Secular stars in the making

The stars are slowly aligning across the investment universe as we enter the final quarter of the year. Inflation is receding, a US recession looks distant, and corporate profits are recovering—all as the global equity rally takes a breather and bond yields test year-to-date highs.

We think the more balanced outlook and entry point suggest positive returns are possible across a range of asset classes over a 6–12-month horizon. But investors in Asia still need to contend with two key potential risks: A slower-for-longer China and higher-for-longer US rates. Indeed, regional markets most exposed to mainland Chinese demand and tighter US financial conditions—i.e., South Korea, Taiwan, Singapore, Hong Kong, and mainland China—have underperformed global equities by mid-single digits on average since the start of August.

To navigate these challenges in the quarter ahead and beyond, we look to secular stars in the making. India and Indonesia, once considered part of the “Fragile Five,” are now shining in EM Asia, while Japan is likely to be the only advanced economy to grow above potential next year. By sector, we see structural growth opportunities from technological disruption, and upgrade tech to neutral in our global strategy this month.

China: A maturing star

China, however, remains at the center of Asia’s financial solar system. Here, the intensity of policy easing, particularly in the property sector, has meaningfully stepped up and recent data points (PMIs, trade, CPI, credit) suggest a sequential growth improvement in August.

While more support is likely needed to stabilize property sales, the recent developments are in line with our base case of a cyclical recovery close to official government targets by year-end. In the near term, we expect that recovery to support cyclical growth beneficiaries (internet, consumer, materials, industrials).

But as early as next year, China is set to transition into a period of slower structural growth. After averaging an astronomical 10% growth per year in the early 2000s, and around 6–7% over the last 10 years, we expect a slowdown to 4–4.5% in the next decade as the economy rebalances away from property and contends with aging demographics and geopolitical pressures.

That still means China will account for nearly a third of all global economic expansion, with growth centered around consumption, manufacturing upgrades, and tech innovation. And with GDP per capita around just one-sixth of the US, there remains significant scope for a productivity catchup. Over the medium to long term, that means investors will need to gradually shift their focus from cyclical growth beneficiaries to structural growth beneficiaries that also offer a degree of defensiveness, such as renewable energy and EVs.

India and Indonesia’s time to shine

While China slows, we see India and Indonesia shining over a multi-year horizon. India is already on track to become the world’s third-largest economy by 2030, supported by 82mn working-age people entering the workforce each year through 2030, comprehensive reforms, and global supply chain restructuring. We think that higher foreign direct investment could double the economy’s share of global manufacturing by the start of the next decade. In an early sign of that, India already accounted for 7% of global iPhone production in 2022 (vs. just 1% in 2021), and that slice is expected to rise to 25% over the next few years.

Meanwhile, Indonesia is also enjoying an FDI revival on the back of earlier reforms, a larger EV and energy transition supply chain footprint, and a rapidly growing consumer class.

These megatrends make India and Indonesia our most preferred equity and currency markets in Asia. We like leading internet platforms, consumer electronics, and IT services in India, and ride-hailing names in Indonesia. The high-yielding INR and IDR should continue their regional outperformance given a more conducive carry trade environment as central bank rate hikes end.

Japan on the rise

Japan’s bull market has resumed after a summertime lull. Foreign inflows this year have been the strongest in a decade, yet we think the Japanese equity market is still largely underowned and underappreciated by overseas investors after generations of underperformance against US equities. A deeper fundamental dive shows Japanese companies are in fact more profitable than ever before and have delivered EPS growth on par with the US over the past 10 years—but total returns have been eroded by a contraction in valuation multiples. From a structural perspective, Japan is finally escaping profit-sapping deflation with domestic inflation at the highest since 1981, and corporations are more focused than ever on delivering shareholder value.

While we forecast moderate returns over the next 6–12 months on an index level, we think the risks are skewed to the upside as structural growth drivers become clearer in the quarters ahead. For now, we recommend first building longer-term positions in a basket of quality value and domestic names. The value outperformance in Japan has been a unique feature compared to other developed markets, and we expect this to continue as segments like banks benefit from the gradual Bank of Japan policy normalization we see through 1H24, and domestic-oriented names profit from reopening spending and continuous wage growth in 2024.

The persistently weak yen has been another tailwind for corporate earnings this year. We expect the currency to gradually recover (to 139 against the USD by June 2024) as the BoJ progressively allows JGB yields to drift higher, but not to levels that reverse the benefits for companies with high overseas exposure.

US yields to fall

Another support for equities should come from a gradual stepdown in US yields. Historically, yields tend to peak in the months ahead of a final Federal Reserve hike, which we think has already come and gone this cycle. As inflation continues to cool globally, we forecast total returns of 10–15% over the next six to 12 months for quality fixed income (see our capital market assumptions for more). To position, we continue to advocate increasing duration via a barbell strategy: Add exposure to long-dated (7–10-year) bonds from high-quality (single-A or higher) issuers, while reducing volatility by adding in the short end of the curve (1–3 years), where investors can also take on more credit risk (BBB rated names) for solid income generation. At current yield levels, we believe negative returns an over 12-month investment horizon are highly unlikely.

An August pullback in prices also improves the risk-reward for Asia tech, where valuations now stand at only 16x 2024 P/E, a significant discount to global tech’s forward P/E of 26x. Driven in part by AI, we project more than 50% earnings growth for tech in 2024—the highest among all sectors in the region. To position, we think Asia’s supply chain companies, particularly in Taiwan, are particularly well placed in areas such as the graphics processing unit (GPU) value chain, AI-based servers, and networking hardware. As demand in other tech segments also broadens, we like Korean memory names, regional smartphone and PC suppliers, Chinese software and cybersecurity, and select Chinese and Southeast Asian (ASEAN) internet laggards.

As 4Q begins, we see a more balanced investment outlook where stocks, bonds, and alternatives can all deliver reasonable returns over the next six to 12 months. But some stars shine brighter than others in today’s multi-asset opportunity set, and this is reflected in our preferences across the region and beyond.

Written with?Mark Haefele, our Chief Investment Officer.

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