Asia: bull or bear in the Year of the Goat

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Since 1973, the Year of the Goat has generated the highest average returns among the 12 Chinese zodiac symbols, averaging an impressive 45.3% each year, according to JP Morgan.  Leaving superstition aside, there are some strong fundamental reasons why equity markets in Asia can make like a bull in the Year of the Goat, 2015.

The growth premium appears to be re-gaining ground

Asia’s reputation as a high growth region came under pressure during the last few years as the growth premium narrowed. This is a key reason why the region has de-rated since 2010. However, it appears as though the growth premium has bottomed out and is now beginning to regain some ground. As global growth also improves, the high beta nature of Asian economies begins to work in their favour, not against them. This higher return potential suggests Asian equities are increasingly relevant in an investor’s asset allocation even when considering the higher risk nature of the region.

The slowdown in China shouldn’t be seen as a ‘negative’

While China is experiencing a slowdown in growth, this in itself is not a negative for equity markets. The Chinese equity market tends to get excited when real Gross Domestic Product (GDP) growth is above ‘potential growth’ and sells off when real GDP slows below potential growth.

But 2015 could mark the year in which Chinese growth rebases after stimulus-led excesses and real GDP growth are expected to remain in line with potential growth. At the very least, this should not provide another reason for a de-rating. As risk sentiment normalises and volatility subsides, risk aversion should be a buying opportunity when coupled with attractive valuations.

Earnings expectations have improved

Earnings expectations for Asia excluding Japan in 2015 are the most realistic they have been in years. Consensus is forecasting earnings per share growth of 9.5%, which is below the usual starting point of around 15% and the five-year compound annual growth rate of 11.4%. This provides some comfort that the downside risk to earnings estimates is relatively low.

We believe the earnings upside will come from margin expansion. Asian net margins are at their lowest level since the financial crisis but appear to be bottoming out. Margin expansion in the coming period is expected to be driven by a combination of lower commodity prices, lower interest expenses, less wage pressure and faster revenue growth.

This year, the opportunities for creating alpha appear the best since the global financial crisis. The correlation among stocks in Asia has declined to five-year lows. This is true whether analysing the correlation between the largest ten stocks in the regional index, the largest stocks in each country or the largest stocks in each sector.

Asia is going through a process of reform, with many governments taking the window of opportunity to reduce subsidies, make State Owned Enterprises more efficient, improve tax systems, introduce foreign direct investment and private capital and enforce environmental standards. These reforms are critical to overcoming some structural weaknesses that have been brought to light by the cyclical slowdown. Most reforms are market friendly and should help drive a market re-rating.

Risks

Two recent events that were cause for concern – the quantitative easing decision by the European Central Bank and the Greek Election/Exit – barely registered. There is risk around when the US will raise interest rates. Our view is it may be delayed into late 2015 or even 2016 due to deflation and a lack of wage growth. With liquidity conditions from Europe, Japan and China remaining supportive, this is not the greatest risk to Asia.

The greatest risk is a Japanese-inspired currency war due to the Bank of Japan Governor Kuroda’s steadfast refusal to budge from the 2% core inflation target. This is because the Japanese definition of core includes the price of oil. If the target is not revised lower or to a core ex-oil target, another round of quantitative easing will no doubt be needed. The resultant yen weakness could force competitive devaluations by other Asian countries, with Korea one of the biggest casualties.

The Chinese property market and debt build-up remain an ever-present risk. This has spawned a greater and more immediate risk of capital flight. In the fourth quarter of 2014 alone, the capital outflow amounted to Rmb600 million by some estimates. Luckily, this liquidity reduction was exactly offset by the Reserve Requirement Ratio (RRR) cut. China has more fire power to do so with RRRs at 17.5-19.5%. Even if the ‘hot money‘ outflows are stemmed, there is a structural trend for more outward foreign direct investment. A prime example of this is the formerly unheard of Anbang Insurance’s US$2 billion purchase of New York’s Waldorf Astoria. This occurred after insurance companies were mandated to invest up to 15% of their capital offshore.

Portfolio positioning

We are overweight Asian equities from a dynamic asset allocation perspective. Within the region, our portfolios’ positioning is overweight China, Indonesia, India and the Philippines. However, stock selection remains paramount in light of the alpha opportunities and the concurrent risk.

Notwithstanding the risk of war – currency, physical or in cyberspace – Asian equity fundamentals look attractive. Valuations are supportive with realistic earnings estimates. Earnings upside comes from margin expansion on the back of falling commodity prices, lower wage pressure, faster revenue growth and lower interest rate cuts. The latter will also help drive a re-rating as the cost of equity falls as will an improvement in return on equity. All in all, we support the case for being a bull in the Year of the Goat.

 

Casey McLean is a Portfolio Manager and Analyst with AMP Capital Asian Equities. This article provides general information and does not address the personal circumstances of any individual.

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