Go east for hidden value
Asia is offering compelling investment opportunities, though not necessarily in the places one might expect.
Fundamental economic conditions within the region have improved significantly and equity valuations remain undemanding, particularly relative to the later-cycle US market.
No place is immune from developments outside its borders and the US remains in many ways the tail that wags the dog in Asia.
Fluctuations in US Fed policy interest rates and the value of the US dollar can have wide-ranging effects on a region where many countries still peg policy to Washington.
The risk implications are both cyclical and structural.
On the cyclical front, an inflationary overheating and disorderly rise in interest rates in the US could prompt aggressive Fed policy tightening, prematurely curtailing Asian expansionary conditions.
Alternatively, a deflationary bust and recessionary conditions in the US could severely curb risk appetite in Asia.
However, the core thrust of US economic policy should be favourable for Asian equities.
The Fed wants a gradual and orderly normalisation of policy, which would likely support the earlier-cycle, undervalued markets in Europe and Asia.
President Trump wants to bolster growth with fiscal stimulus, which would likely benefit Asian markets also given their sensitivity to the US dollar and the global economic cycle.
The most significant action taken by Trump thus far vis-a-vis Asia is to withdraw from the Trans-Pacific Trade Partnership.
Yet this is not a negative for Asian stocks.
The US withdrawal creates a regional vacuum China looks well-positioned to fill. The 11 remaining countries from the original pact are forging ahead with a free trade zone that will account for roughly $10 trillion in annual economic output.
The structural implications largely involve US currency and its balance of payments. Supply and demand dynamics in the US government’s funding market are changing.
Washington will likely increase debt issuance to fund its deficit at a time when the Fed and European Central Bank (ECB) are winding down bond purchases.
Western savers and central banks have been key sources of demand for US debt, but their reduced appetite could result in Asian savers and governments stepping in to soak up the extra liquidity, hastening the shift away from dollar hegemony and spurring a flow of funds from west to east.
Value in unexpected places
Asian bourses tend to have high concentrations in financials, technology and commodities. While these sectors offer bottom-up opportunities, their popularity often obscures opportunities elsewhere.
Some of the best structural growth opportunities in Asia are plays on the long-term wealth accumulation and demand potential of Asian consumers.
The telecommunications and utilities sectors are two such examples. Companies like China Mobile and China Telecom, offer bargains.
While the market continues to focus on perceived negatives such as unlimited data pricing competition and the high capital expenditure forecasts associated with the buildout of the nation’s 5G network, these telcos are trading at undemanding valuations that are growing earnings and dividends and investing to gain scale and share in a growth market.
Select Asian utilities also offer lowly-valued exposure to Asian growth trends. Hong Kong-listed gas infrastructure company Kunlun Energy is an example.
After transitioning from a poorly run, state-owned energy company to a better-managed gas distribution utility, it looks well-positioned to stabilise earnings and capitalise on an uplift to both margins and volumes.
Taking a broader view beyond sectors, Japan and South Korea (and to a lesser extent, China) offer compelling opportunities.
Japan is one of the few markets that are under-owned and trading at a discount to its historical valuation levels.
Japanese GDP is growing at an above-trend pace, Nikkei earnings per share recently reached their highest level since 1991, and non-financial sector net debt-to-EBITDA (earnings before interest, taxes, depreciation and amortisation) recently fell to the lowest level in three decades.
Japanese equities are now trading on par with developed world peers on cyclically adjusted earnings multiples for the first time in twenty years.
Issues relating to ageing demographics and high government debt persist, but Japan is heading in the right direction.
In South Korea, corporate earnings are rising and the won is appreciating on the back of strong export growth.
Yet, as with Japan, valuations have yet to follow suit. Despite rising 45 per cent in US$ terms in 2017 alone, the MSCI Korea Index trades at a lower forward P/E than it did at the beginning of the year.
Some policies introduced under President Moon have rattled investors. Nevertheless, the Moon administration has also progressed with shareholder-friendly efforts to reform the large chaebol conglomerates.
China’s systemic importance gives it the potential to disrupt regional equity markets if the government fails to cool financial speculation and transition to a more sustainable economic model without materially slowing growth.
While China’s massive debt burden and economic imbalances will eventually need to be addressed, the ability of China’s central planners to promote stability in the meantime should not be underestimated.
The country offers an interesting combination of high growth and cheap valuations for some companies, and the best opportunities exist among lowly-valued H-Shares in the service-oriented sectors.
In summary, Asia appears more resilient today with better current account balances and less exposure to foreign-denominated debt.
Many Asian markets appear modestly valued and highly levered to the improvement in the global growth cycle, which could accelerate further following US tax reform and fiscal stimulus.
A weaker dollar as the US budget deficit widens, and the subsequent rise in commodity prices, also suits these markets well.
Peter Wilmshurst is a portfolio manager at Templeton Global Growth Fund Ltd.
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