04 January 2018
Asian equity markets reminded investors of their potential in 2017. This insight from the Macquarie Asian Equity team, reflects on the key themes that drove Asian markets. Highlighting the continued transitions in China, the impact of global demand for electronic goods and the outcomes of further economic reforms in the region. Does the year that was 2017 herald a return to form for Asian Equities?
2017 was a very strong year for Asian markets, with the continued economic strength of China and a compelling rally across the Information Technology (I.T.) sector in the region producing substantial returns for investors (based on calendar year to date (CYTD) returns of the MSCI AC Asia ex Japan Index as at 30 November 2017). As the largest market in the region the health of China is a key catalyst for regional growth. During 2017 China dispelled many of the concerns at the forefront of investors’ minds; the health of its external accounts, ability to rebalance its economy towards consumption and a renewed focus of deleveraging, have all contributed to a strong year of growth and sentiment. The upbeat sentiment towards China was reflected in the performance of its stock market with the MSCI China Index, as at 30 November 2017, generating 11-consecutive months of gains to produce a return of over 50% for the year, crowning it the best performing market in Asia.
Overall, it was positive to see that the strong market performance of this region in 2017 was supported by fundamentals. Earnings growth expectations in Asia were bullish during 2017 and outpaced other regions globally; this optimistic corporate outlook has underpinned the outperformance of the region's stock markets. Earlier in the year the majority of earnings upgrades were witnessed in China and South Korea, largely driven by improvements in the I.T. and Materials sectors. Toward the end of the year, earnings expectations had also risen across other countries and sectors in the region. As illustrated in the graph below, the rising expectations for corporate earnings in Asia signaled a clear tone of improved optimism in comparison to the rest of the world, propelling Asia's markets to outperform in 2017.
Next 12 months EPS* (rebased to 100 every 1-January)
Source: Macquarie, Bloomberg, MSCI, S&P. Data as at 30 November 2017
*Next 12 months EPS refers to a rolling next-12 month window of earnings estimates for companies’ earnings per share (EPS). 'Asia ex Japan' refers to the MSCI AC Asia ex Japan index, 'United States' refers to the S&P 500 index and 'Europe' refers to the MSCI Europe index.
China firmly in the driving seat
Asia in 2017 saw strong performance from the ‘old economy’ sectors in a rally that was predominantly driven by China ('old economy' is defined as heavy industry and manufacturing). A Chinese property boom drove much of the country’s impressive economic growth, with the country averaging almost 6.9% GDP growth during the year and easily beating the consensus expectation of 6.5% (Source: Bloomberg, as at 30 November 2017). As the world’s largest importer of commodities, China’s property expansion drove global commodity prices higher. With property accounting for approximately 30% of total steel demand in China (Source: China Iron and Steel Association, CLSA and Mysteel based on estimates made during 2016) the windfall for this industry was seen as inevitable, but the positives were felt across a number of ‘old economy’ industries; producers of building materials, cement, copper, iron ore and, of course, steel all recorded significant increases in demand.
The combination of rising demand, largely driven by property investment, and higher producer prices drove significant industrial profits, as depicted in the China PPI and industrial profits graph below. 2017’s strong demand environment allowed China to make meaningful progress on its supply side reforms, with reductions to production capacity easier to implement when profits are healthy. One of the most encouraging signals of industrial health is evident within the steel industry which, long maligned as an industry of acute over-capacity concerns, has witnessed a clear turn-around in profits. Between 2015 – 2017, the proportion of profitable steel producers in China rose from just 5% to 86%, a stark contrast and evidence of the impact higher commodity prices are having on the balance sheets of Chinese industrial companies. (Source; Mysteel, JPMorgan as at 3 November 2017).
China PPI and industrial profits
Source: NBS, J.P. Morgan. Data as at 31 October 2017
China’s debt accumulation is undeniably an area to monitor closely, however in 2017 we observed signs of improvement both at the policy and corporate level. Firstly, an improvement in the profitability of State Owned Enterprises (SOEs) has resulted in improved debt servicing ability (this is significant as SOEs account for approximately 60% of China’s total corporate debt)(Source: PBOC, CEIC, JPMorgan as at 31 December 2016) secondly, Supply Side Reform has stemmed credit growth in unproductive industries (such as steel and coal), and thirdly the government’s crackdown on Shadow Banking has materially reduced the worrying credit growth in this opaque sector (unmeasured shadow credit reversed a trend of steady growth by contracting 3% quarter on quarter in 2Q17)(Source: NBS, PBOC as at 22 September 2017). Against this backdrop, we saw China experience their first quarterly decline in debt levels since 2011 and whilst the jury is still out on the nation’s commitment to debt reduction should GDP growth stagnate, it is a clear and encouraging sign that the issue is at the forefront of the government’s agenda.
2017 marked an important year for China’s reform agenda to rebalance its economy toward higher quality, consumption-led growth as the nation’s top leaders came together for the five-yearly congress of the Chinese Communist Party to set the medium-term policy agenda for the country. While much of the media coverage following this 19th congress was focused on the changes to key leadership positions and other political developments, we view it as a positive that the government continues to emphasise its broad economic agenda, promoting growth quality over quantity. Key components of the government’s economic agenda include rebalancing towards consumption-led economic growth, driving productivity improvements, reforming SOEs, boosting international competitiveness, promoting innovation through projects like the Belt and Road Initiative and increasing investment in areas such as alternative energy and green technologies. This political agenda signifies a clear shift in priorities as quality is favoured above the rapid, debt fuelled growth China has recently been renowned for. While high levels of indebtedness and the nation’s ability to achieve an orderly economic transition remain looming concerns, President Xi Jinping’s increasing political power suggests there are fewer reasons to doubt he’ll be able to stay on course to achieve these goals.
As China continues to grow, it becomes increasingly important and relevant for both the regional and global economy – it’s expected to add more to global GDP over the next 3 years than the U.S. and Eurozone combined (Source: IMF, World Bank as at 19 May 2016). The world’s exposure and reliance on China has shifted significantly in recent years; today, trade with China accounts for at least 10% of total exports or imports for over 20 countries, up from just 3 countries in 2000 (Source: IMF as at 31 May 2016). The well-being of China’s domestic economy has never been more important to the rest of the world, as the translation from Chinese growth into global growth continues to strengthen.
Demand for Tech continues
A sector where both China and the Asian region’s international prominence is well established is in the Information Technology sector and the rally of this sector was a key component of Asia’s strong market returns in 2017. Demand was well supported by the year’s iPhone launches and the expectation of larger orders for manufacturing components. Another less well publicised dynamic has been the strong price increases for a particular type of semiconductor memory, Dynamic Random-Access Memory (DRAM), widely used in electronic goods. The DRAM price increases were a result of growing demand for memory production from a consolidated and supply constrained industry. This has been a particularly important trend in 2017, resulting in both a divergence of returns between the larger market capitalisation ‘all-cap’ index (MSCI AC Asia ex Japan Index), which has a much larger weighting of tech names in comparison to the smaller market cap index (MSCI AC Asia ex Japan Small Cap Index), as well as supporting the returns of tech-heavy markets such as South Korea and Taiwan. Taiwan’s critical role in the iPhone supply chain meant the increased demand led to a marked increase in the nation’s exports (Source: CEIC as at 30 November 2017). In South Korea’s case the strong performance of I.T. stocks has helped insulate the market from any negative sentiment associated with the tensions on the Korean peninsula. Instead the market seemingly took its cues from more positive domestic developments, including the May appointment of Moon Jae-in as South Korea’s 19th president. This helped clear a period of political uncertainty and led the South Korean index (MSCI Korea Index) to an all-time high.
Reform continues in India
Following the surprise and disruption caused by the demonetisation policy in late-2016, 2017 also proved to be eventful in India as Prime Minister Modi further progressed his reform agenda with a number of potentially game-changing policy developments. One of the most important reforms this year was the successfully passed goods and services tax (GST) law which is widely hailed as a major and necessary step toward improving and streamlining the country’s complex taxation system. During the year however, it was the flow through impacts of the demonetisation event that captivated the market for much of the year. In early November 2016 the Indian government announced the cancellation of high-denomination bank notes which saw 86% of total currency in circulation taken out of the economy overnight. Whilst it was expected this initiative would eliminate “black money” from the economy, the latest Reserve Bank of India’s annual report shows that in 2017 99% of the Rs15.4tn worth of currency notes that were demonetised have been re-injected back into the financial system (Source: RBI as at 30 June 2017). With all this money flowing back into the economy, what we witnessed was a huge flow of domestic savings invested into Indian equity markets in the presence of relatively low asset yields; in a region where earnings growth broadly disappointed in 2017, this pushed valuations in India to extreme levels. Since the start of 2017 Indian domestic investors have purchased over US$8bn of domestic equities which has seen a greater flow of money towards SMID cap companies, pushing the MSCI India SMID Cap Index up more than 50% (USD) in 2017 (Source: HSBC, Bloomberg as at 30 November 2017).
All Asian economies not equal – but elections looming
South East Asian markets have been laggards in 2017 as lacklustre domestic growth fails to entice investors back into the region. Although a number of economies in this part of the world are beneficiaries from the pick-up in global growth, particularly the more export-exposed economies such as Singapore, Thailand and Malaysia, there is unfortunately little evidence yet that this translated into the broader economy with private investment and credit growth running beneath levels of GDP growth. With inflation benign and domestic demand lacking, central banks in South East Asia are showing a greater willingness to diverge their monetary policy from the US Federal Reserve’s tightening cycle by keeping monetary conditions easy, even making outright interest rate cuts as was the case for Bank of Indonesia. Thailand, Malaysia and Indonesia all have general elections in 2018, and investors are watching for signs of increased fiscal stimulus, through commonplace pre-election spending, as a stimulant for economic growth. Government balance sheets are typically conservatively managed in this region and we believe there is scope for expanded fiscal stimulus, likely in the form of infrastructure spending, but possibly also in tax cuts, increased subsidies and cash handouts too. After underperforming in 2017, it is entirely feasible that the excitement over election-related fiscal stimulus will be sufficient for investors to once again reconsider South East Asia and be the catalyst for a catch-up in performance.
Capturing Asia’s future growth
Whilst 2017 was a strong year across a number of cyclical sectors, we retain our long-held belief that Asian domestic demand, primarily created by a rising middle class and changing consumption habits, will be the long-term driver of growth in the region. The rebalances in China, the region’s most important economy, are evidence of how these changes are, and will continue to play out. As the world’s most populous continent, with favourable demographics and comparatively low GDP per capita, there remains considerable growth potential across Asia.
Despite the (often rapid) changing market dynamics we remain conservative and patient investors in Asian equity markets. We continue to look for and focus on quality growth stocks, while remaining very aware of the risks of investing in Asia.
With this year’s resurgence in more traditional industries we have been careful to avoid chasing markets and have seen some sectors reach valuations we don’t think are sustainable. Yet, we continue to add select investments that are leveraged to Asia’s sustainable growth themes, believing this approach will be rewarded in the long term.