Time to Check In on Markets
Week of March 11, 2016
Oh, volatility! Having peaked in April of last year and swooned again by mid-year and at the beginning of 2016, Asia is rallying once more. What is going on?
The short and honest answer is, “I don’t know exactly.” But I am willing to hazard a guess. For sure, there are frictions within China’s economy—a high debt load in parts of the corporate sector and just those parts that are markedly slowing—the commodities and industrial sectors. Elsewhere in the region, Southeast Asia is suffering from a downturn in the credit cycle and pressures on currencies. Australia suffers the impact of slowing demand for iron ore and other raw materials, whereas India is laboring under the yoke of a stumbling bureaucracy. Across the region, margins have been falling for the past four years. But when one puts all of these under the microscope, they all seem less serious than headlines suggest.
On Chinese debt, I find myself thinking, “Well, for sure debt is high and has been growing rapidly, too rapidly. On the other hand, savings levels are high and the deposit base has been growing rapidly.” When I look at the issues with commodities, I do consider the cyclical element to this. But even if there is a structural, secular reason for the decline, I know that we do not need to invest there. And Asia’s economies are more driven by the domestic consumer and services sector than people give them credit for. As for India’s bureaucratic woes, I react with: “We knew all of this already. Good businesses can function even as the bureaucracy misfires. But there is all the potential for India to turn things around. Is there too much hope in the politicians being successful? Maybe. But markets tend to be reasonably good at figuring out probabilities. There is a gap between expectations and reality, but who knows how that gap will be closed? As for corporate margins, they are showing signs of stabilizing and valuations are not unreasonable. But, certainly, some of the market weakness is justified given the poor earnings performance of some sectors over the past year.
I still think Asia’s central banks are driving the markets at the moment. And there remains much uncertainty around policy. Let’s start with the U.S. Federal Reserve. It has been tightening for nearly three years now, considering its taper talk and withdrawal of quantitative easing, even before the rate rise in December. The market is worried that it has already done too much. And I would be tempted to agree. However, the Fed can point to rising core inflation and a tightening labor market as evidence that it might have got things just right, thank you very much. We’ll see. But it’s poised on a bit of a knife’s edge as just about every central bank in a rich economy that has raised rates recently has swiftly had to change course. Look at Sweden, where policy rates are now minus half a percent! Meanwhile, the European Central Bank has maintained its reputation as a politically hamstrung institution with a bias toward hard money. Given all this, the slowdown in nominal growth rates in Asia has been significant: in the past four years, according to International Monetary Fund data, nominal growth in GDP (in U.S. dollar terms) in Asia Pacific has fallen from 14.8% in 2011 to 1.2% today; in East Asia, from 15.3% to 3.1%, Southeast Asia from 15.6% to -2.4%. In China, the slowdown over this time period went from 24.1% to 9.9% and in India from 7.9 to 6.4%. In Japan, it slowed from 7.5% to -10.6%.
In this environment, is it any wonder that margins are deteriorating and market performance is weak?
But Asia’s central banks are fighting back against the tight money. Most noticeably Japan. Yes, it has impacted the currency, as we can see from the GDP numbers (in U.S. dollar terms) quoted above, but we also see good performance not only from exporters, but even domestic businesses with higher operating leverage. China, too, is trying to lean against the Fed. It is just that the market has reacted very violently to any suggestion that the renminbi might devalue against the U.S. dollar (USD). And despite its rise against other global currencies and its relative stability versus the dollar, China’s exports are still gaining market share. So perhaps the calls for a big devaluation are a bit overdone? India, which has seen a much more modest deceleration in USD, nominal GDP growth has also been trying to loosen. The constraints here have to do with its core inflation. Tighter money in the past was able to cool the economy without a huge impact on corporate earnings because costs (particularly oil prices) were falling. But now, looser money seems to be starting to impact inflation quite quickly. What is needed is more supply-side reform. The other hint of good news is that, although the currency falls in the region have hurt USD returns, they have not been accompanied by rapidly rising unemployment in the domestic economies. In other words, the currency depreciation has done its job in acting as a pressure valve.
Does this still ultimately leave us in the hands of the Fed? If Asia’s central banks are constrained as to how they can act, we still take orders from the U.S. There has been some softening of the Fed stance recently and I suspect this is what is behind the rally. But even if we are to see future rate rises coming, that will only be the case if core inflation continues to rise. In that environment, it is not at all clear to me that the USD will be strong, though! And, as I hope I have demonstrated, a better nominal growth environment is precisely what the markets in Asia need right now. Indeed, inflation expectations in the U.S. are rising again, and this has been concurrent with the rally in markets. And there are also other things Asia’s governments can do. Generally, high savings and good budget positions for many countries mean fiscal policy is an option too. Thailand has just announced a series of tax cuts. This could be copied elsewhere in the region.
I wish valuations were a bit cheaper. FactSet Aggregates have the Asia ex Japan dividend yield at 2.9% and Japan at 2.1%—above average, but not screamingly high! In a world of negative policy rates and a U.S. 10-year Treasury yield at 1.8%, that is not too bad though. Particularly, when you consider that Asia remains the part of the world with the highest savings rates and fastest rates of long-term productivity growth.
Ah, volatility! I also understand it goes both ways: up and down. And there are stabilizers in the environment that prevent me from getting too pessimistic: valuations, central bank actions, currency moves, and fiscal stimulus. All these play a part in keeping demand stable and letting the region’s long-term growth drivers work. So, I keep my eyes on the central bankers these days. For the most part, though, we continue to focus on companies with strong secular growth, rather than trying to time the central bank-controlled cycles. The challenge for portfolio managers remains to identify these companies and not to overpay for their prospects. We still believe that investors will benefit from patience when investing in Asia and stick with companies whose management teams are investing wisely in the business and sharing growth with minority shareholders
Robert Horrocks, PhD
Chief Investment Officer
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