World Investment Outlook - Chapter four: Asia

It is hard to believe that the 19th Communist Party Congress in China, the fall and arrest of a President in Seoul and a hung Parliament in New Zealand could be so comprehensively overshadowed, but North Korea’s nuclear and missile tests managed precisely that in 2017.

The foreign policy of Kim Jong-un will remain front of mind for anyone with financial exposure to the Asian region, although it may be that the solution is a simple one – rain. North Korea is suffering its worst drought in 16 years and when food is scarce any leader needs to distract his people and find a foe to blame for their woes.

Now that the five-yearly Party Congress is over China’s President Xi Jinping, can focus once more on balancing the need for growth against the country’s gathering debts. In India Prime Minister Modi will be looking to push ahead with this reform programme and overcome the blip in growth suffered after the controversies surrounding both demonetisation and the launch of a new Goods and Services Tax (GST).

Rising earnings estimates and falling interest rates in key countries such as India and China provide a helpful backdrop for Asian equity markets in 2018, adding to longer-term factors such as modest debts (compared to the West) and more favourable demographics. Whether the Apple effect proves helpful or not is more open to debate although Asia is home to many potential plays on the rise of electric vehicles, as well as a growing middle class and domestic consumption.

Economics

India remains a hot investment story, as evidenced by a terrific run in the country’s stock market SENSEX index that dates back to early 2016, and one reason for this is the roll-out of the Aadhaar, a national identification scheme. Over 80% of India’s 1.4 billion population has joined since 2009 and each person now has a unique number based on biometric data such as retina scans and fingerprints.

The system has helped tax collection but even more importantly it has encouraged nearly 300 million Indians to open bank accounts so they can use Aadhaar’s Universal Payments System (UPI). That makes it easier for the Government to pay benefits and easier for consumers to spend or put their cash with the banks, who are enjoying steady growth in deposits which they can in turn use to make loans. India’s state-backed backs may still be weighed down with underperforming loans but private-sector bank loan growth is still running at 5% to 6% year on year, even after the double-digit boom years of 2011 to 2014.

Although India’s internet penetration rate of 37% still lags China’s 53%, further infrastructure investment should help here, especially as Aadhaar means over 80% of Indians now have a mobile phone.

Bad loans at the public banks must be watched, but total credit to GDP is barely 50% in India compared to over 200% in China and household debt to GDP is only just over 10%, against nearly 40% in India.

However, India had to negotiate some bumps in the road which meant that GDP is lost some of its momentum before a welcome rebound in the third quarter of 2017.

India did lose some economic momentum in 2017

Source: Thomson Reuters Datastream

• The first is the so-called demonetisation programme of 2016, which did cause chaos. The forced exchange of old R500 and R1,000 for newly-printed ones seemed to hit cash-reliant smaller and medium-sized enterprises especially hard, with the result that GDP growth has slowed markedly and left India struggling to meet the International Monetary Fund’s forecasts of 7.2% and 7.7% increases for 2017 and 2018. Bulls of India will be hoping this is just a blip, especially as the Reserve Bank of India went ahead and issued new R200, R50 and R20 notes in the autumn.
• The second is the launch of a new goods and services tax in July 2017. This levy, the equivalent of VAT here in the UK, was introduced at every point of sale to replace a complex and confusing web of local indirect taxes. The idea was to create a simpler system, close loopholes, cut logistics costs and ultimately boost the economy, although smaller, cash-oriented businesses again found the transition difficult to manage.

India’s lowly debts are therefore one long-term attraction of its economy, especially as 2017 represented the twentieth anniversary of the Asian debt crisis, when Thailand, South Korea, the Philippines and Indonesia all had to devalue their currencies and accept help in exchange for austerity programmes imposed by the International Monetary Fund (IMF).

Although corporate borrowing is creeping higher in some areas, sovereign debts remain low, with even China’s state-level liabilities representing only 46% of GDP.

However, the Chinese number is a tricky one, as a lot of liabilities rest in the grey area that lies between the state and the private sector, in the form of the State-Owned Enterprises (SOE). Bank of International Settlements (BIS) estimates put the nation's total-debt-to-GDP figure at 255%, while McKinsey Global Institute analysis suggests China’s debts have quadrupled since 2007. Given those numbers it may not surprise investors to learn that Standard & Poor’s cut China’s credit rating to A+ from AA- in September, following Moody’s move to A1 from Aa3 in May (the agency’s first downgrade of Chinese debt since 1989).

This partly reflects the fiscal and monetary stimulus which China is using to keep growth on track. This can also be seen in the so-called Li Keqiang index, based on three indicators which the Prime Minister is believed to follow in preference to official Government growth statistics. This trio comprises:

• Demand for loans
• Rail cargo traffic
• Electricity consumption

The Li Keqiang index made a comeback in China in 2017

Source: Bloomberg, Thomson Reuters Datastream

It very much represents old, industrial China rather than the new, technology, e-commerce-led one and although the readings improved (at least in early 2017), this reliance on capital investment and exports rather than services and consumption suggests China has a long way to go before it rebalances its economy.

One quick way of keeping tabs on China’s economic progress is to monitor the currency, the renminbi. The growth scares of summer 2015 and early 2016 both showed up first in weakness in the renminbi against the dollar. The more serene progress of 2017, aided and abetted by substantial stimulus ahead of the Party Congress, saw the renminbi rally strongly.

Markets

Whether the solution is sustainable or not, Chinese equities found their footing again in 2017. The Shanghai Composite forged a break away from the 3,000 mark around which it had gravitated since 2015’s thumping market correction, although the index did then begin to lose ground as 2017 drew to a close.

Add a strong performance from India to the still-positive returns from China and it is no surprise to see Asia rank top of the eight major global regions, when measured in total returns in sterling terms for 2017.

Asian equity markets ranked first out of eight in 2017

Source: Thomson Reuters Datastream, based on MSCI Asia Pacific ex-Japan index. Total returns in sterling terms, 1 January to 30 November 2017.

When it comes to assessing potential future returns, it is worth bearing in mind that Asian stock markets are dominated by three industrial sectors: technology, financials and basic resources.

Basic resources is currently contributing strongly, buoyed by rising metal prices, capacity cuts, cost-reduction programmes and copious free cash flow from key Aussie miners, although a fresh slump in iron ore and the industry’s tendency to forget its disciplines when times are good mean fund managers will continue to ponder whether the turnaround is sustainable or not. The good news is that commodities now represent just 15% of total regional earnings, down from 44% in 2003, according to research from US-based money manager GMO.

Technology is a powerful influence in Korea, Taiwan, India and China in particular. The Apple foodchain remains a huge factor, notably via the component makers of Taiwan and Korea. In the latter case, silicon chip makers Samsung Electronics and SKHynix now make up around 40% of the MSCI Korea benchmark index.

Another technology sector that remains red-hot is China’s blossoming internet and e-commerce boom. Over one billion Chinese now have a mobile phone and the volume of payments being made via portable device is mushrooming. The problem here is that Baidu, Tencent and Alibaba come with valuations to match.

The investment case for financials rests upon the relatively low levels of indebtedness across the region and powerful demographics.

In addition, Asia is blessed with a strong crop of dividend-paying stocks.

Asian markets ranked by dividend yield

Source: Thomson Reuters Datastream

The MSCI Asia-ex Japan index’s 2.8% dividend yield exceeds that on offer from the USA or the MSCI All-World benchmark and while it may lag the UK’s 4%, that figure comes with much better earnings cover. Asia’s pay-out ratio of barely 40% (and thus cover of 2.2 times) compares to 60%-plus in the UK (and thus cover of barely 1.6 to 1.7 times).

On the growth front, for all that India’s economic prospects look tantalising, its SENSEX index has gone up like a rocket to fresh all-time highs around the 32,000 mark and as a result stocks do look pricey.

India’s Sensex index stands at an all-time high

Source: Thomson Reuters Datastream

A forward price/earnings ratio (PE) in the mid-20s is high by the market’s historical standards and relative to the 13 to 14 times multiple currently attached to emerging markets (EM) overall.

Russ Mould, AJ Bell Investment Director

Next chapter

Read more from our World Investment Outlook 2018 series:

World Investment Outlook - Chapter one: UK

World Investment Outlook - Chapter two: USA

World Investment Outlook - Chapter three: Japan

World Investment Outlook - Chapter four: Asia

World Investment Outlook - Chapter five: Western Europe

World Investment Outlook - Chapter six: Emerging Markets