Growth may have slowed in Asia, but it remains robust at both country and company levels. Investors taking a longer than six-month view can find opportunities across a range of sectors.
Although Asian equities have not performed well this year, we remain positive on the fundamentals and believe the region offers many interesting investment opportunities.
Worsening credit conditions and slowing growth in America and Europe have had a knock-on effect, but the real problem has been the perception of inflation as a result of high energy and food prices. Given that most of Asia is still developing, energy and food tend to be large items in the national consumer price index (CPI) baskets, and inflation clearly acts as an additional tax on the consumer. In addition, materials costs have been rising more generally, with higher prices for steel and plastics reducing the margins for manufacturers.
However, the reason for the blow-off in inflation at the end of this cycle was the strong growth rates experienced in Asia, particularly in China and India. Commodity bulls would argue that this is a structural change and that the era of deflation has ended, replaced by one in which China, in particular, now exports inflation.
Our view is that although structural changes are clearly underway, the reduction in demand as a result of slowing growth is enough to bring most of the commodity complex back down towards more rational levels. Classically, commodity values should tend back towards their marginal cost of production. If there is an area ripe for investment it is exploration and production on a range of materials and energies, and the commodity inflation of recent years has sparked a global wave of capital expenditure to bring supply back into balance with demand.
For Asia, the key question is whether the higher price levels will become endemic; that is, whether wage expectations will become unanchored. Apart from some sharp increases for manual and assembly workers in China, principally affecting the heavily deflationary electronics industry, there is little evidence of this. Our base case, therefore, is that as commodities continue to moderate in the coming months, inflation will also ease and the imperative will naturally shift back to growth.
To put this in context, China may well be able to achieve 9-9.5% GDP growth this year, while growth in Europe and America is stagnating. Similarly, India achieved second-quarter annualised GDP growth of 7.9% and may hit 7-8% for the full calendar year. Given that these are now globally significant economies, these are not trivial growth rates.
There is still significant balance sheet strength in Asia at country, company and household levels, with the exception of South Korea, which sports “Western” levels of household indebtedness. On the government side, this means that those countries that have been significant exporters of manufactured goods and natural resources, such as China, Indonesia and Malaysia, have fiscal surpluses that can be used to pump-prime their growth through infrastructure spending.
For example, China has its ambitious 11th five-year plan, which is estimated to be $920 billion (£525 billion) in direct infrastructure spend by the government. The focus is on power generation and transmission and on the railway industry. This kind of spending is not going away and, indeed, the Chinese may be prepared to use the tax system to further help re-accelerate growth.
Our view, therefore, is that Asia ex Japan remains in good economic health. Although growth has slowed, it remains firm compared with other regions. Asian economies also lack the heavy reliance on credit that is now causing problems in the West. Having been through the trauma of the Asian financial crisis of the 1990s, many firms are not keen to use debt, and indeed a weakness of Asia for a minority equity investor is that many firms are undergeared.
On the implications for the equity markets, we remain positive. Although the correlation between the Western and Asian markets has increased dramatically this year, we do not believe this is reflected in the fundamentals. There has been an overhang in terms of downgrades to consensus earnings numbers that are still to come. In our view the market has been effective at sniffing out weaker earnings and has moved well ahead of sell-side downgrades. In other words, most slower earnings are well reflected in the price.
There are growth opportunities across a range of sectors. The missing link is liquidity. This explains why the correlation has been so high and why Asia has underperformed its developed market peers so dramatically.
Strong interim results for several companies were ignored by the market, but they have not been ignored by managements and major shareholders, many of whom are buying back shares and increasing their stakes.
We have also seen a pick-up in merger and acquisition (M&A) activity. This is reflected in a return of private equity interest and in an increase in trade buying, particularly among electronics firms. Theory suggests that when growth slows the weaker firms fall by the wayside, allowing the stronger firms to consolidate and gain market share. This is beginning to happen in diverse sectors such as notebook casing, Korean office paper and Chinese property.
In conclusion, the fundamentals of the Asian growth story remain intact. At country level, infrastructure investment is continuing and even, in some countries, accelerating. Crucially, despite inflationary pressures, governments still have surpluses to fund these activities.
At company level there is still strong growth, balance sheet strength and healthy consolidation. Although credit conditions have tightened, Asian corporates are in aggregate well funded and still have access to capital for M&A and growth.
Many opportunities in Asian equities have been ignored as liquidity has flowed out of the region’s equity markets. From the bottom up we can still find well-funded growth companies across a range of countries and sectors. The key now is timing. It is difficult to speculate on when confidence could return, but if investors have anything more than a six-month view then Asia offers growth at attractive multiples.