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Why should investors consider an allocation to Asia?

Asia is an incredibly dynamic region. While historically much of Asia was classed as developing, the region is fast catching up with developed markets and different sectors of the various economies have progressed greatly in the past 20 years. We only see this trend continuing. GDP growth in Asia is very strong compared to the US and Europe, and given that population growth is higher too, this should further support economic growth. But most importantly, the quality of that growth is better. The rising middle class in the region versus Europe and the US underpin an increasing demand for high quality products. In addition, in terms of research and development spending and the registering of new patents, Asia has overtaken the US and Europe. All these trends are good news for investors, as these are factors that lay the foundations of economic growth, technological advancements and promising new investment opportunities.

What’s the outlook for Asia’s economy?

Many key economic indicators are positive. Overall, they show that economies are recovering from the hit they took over COVID: from an overall activity perspective, India and Indonesia are almost back to normal, while Thailand, Malaysia and the Philippines are also improving. Specific indicators such as manufacturing PMIs (Chart 1), for instance, also indicate that countries such as India are bouncing back strongly.

We also need to consider China. There has been a notable divergence in the performance of the Chinese economy compared to the rest of Asia. But we believe China is on the verge of a turnaround. The credit impulse indicator (Chart 2), which shows the change in credit creation relative to GDP growth, typically marks turning points in economic activity. The impact of China’s policy tightening has resulted in a notably sharp decline in the credit impulse. This is because in previous cycles, the tightening of credit availability was aimed at individual sectors. However, this time numerous industries have been targeted across the economy: credit has been taken away from the economy as a whole very quickly. But now, we are likely to be at the bottom of the latest cycle, and this gives us comfort that a turnaround is close. We are expecting to see a recovery for China over the medium-term.

Overall, if you look at valuations, Asian equities are priced at the lower end versus their own history, and much cheaper compared to the rest of the world. But we should be mindful that there has been significant divergence in equity performance between different countries. While China has sold off significantly over 2021, other Asian countries performed very well. In fixed income, we consider the high yield sector to be very attractively valued compared to other markets. So in summary (Chart 3), we currently have a preference for Asian equities, particularly India, Indonesia and Taiwan, as well as Asian REITs. In bonds, we favor Asian high yield over investment grade and sovereigns. On the currency side we would overweight selected Asian currencies such as the Malaysian Ringgit vs. the Thai Baht and Philippine Peso.
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China has delivered on its promise to open up its financial markets, and as a result foreign investment flows have been very strong (Chart 4). In the last five years, foreign holdings of Chinese domestic equities and bond flows have increased 8-fold. There’s been a strong foreign push into China.
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In terms of what’s going on in China’s economy today, let’s look at the manufacturing purchasing managers’ indexes (PMIs) as they are a very good early indicator of the health of the overall economy (Chart 5). You can see that there is a great divergence between what is going on globally, particularly in developed markets, and what is going on in China. Globally the economy is recovering but China is slowing. The manufacturing PMI in China has fallen below 50 which indicates a contraction. This is driven mainly by the government’s regulatory actions which have focused on a massive deleveraging campaign particularly in the real estate sector. We are still seeing weak retail activity. On top of that, there is an energy shortage which, if it continues, could have a detrimental impact on manufacturing activity and investment.
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The main risks today of investing in China come from policy and regulation. Over the long term, the government has the goal of ‘common prosperity’ focused on areas such as income inequality, financial stability, enhanced social protections and increased environmental protections. Of the regulatory changes implemented so far, those impacting the property sector have had the most high-profile impact to the economy. That is clearly the biggest risk for investors today. Equity valuations have been negatively impacted, while the earnings outlook has also been hurt (Chart 6). In Chinese sub-investment grade bonds (the majority of which are related to the real estate sector), valuations have been hit significantly. However looking at historical data (Chart 7), spreads at today’s levels have often been associated with strong future returns, so this part of the market could be attractive, however you will have to be prepared to withstand high levels of volatility. So overall, current markets could be a huge opportunity for stock pickers.
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