Dire returns from China’s stock market led to a disappointing performance from Asian equities overall in 2022.
Unfortunately, the near-term outlook for 2023 doesn’t appear to be a great deal better at a time when interest rates are rising around the world and China is clinging on to its zero-Covid policy. What’s more, investors remain nervous over both the direction of travel for government policy in China and ongoing geopolitical tensions between China and the US.
It’s not all bad news, however. Valuations in many areas are now cheap, sentiment towards Asian equities is already depressed, and any improvement in the macroeconomic backdrop could spark a sharp rally from current levels over the medium term.
The global macro environment remains very difficult. Central banks in major Western economies, are being forced to raise interest rates aggressively to slow growth and curb the inflationary pressures that have built up in the past 12-18 months. The US may be tipped into recession as the Federal Reserve (Fed) continues to raise interest rates at a very aggressive pace and the country’s housing and labour markets slow. Europe is under even greater strain as rapidly rising energy costs and disruption from the Russian invasion of Ukraine heap further pressure on living costs.
Coming after a long period of very low inflation and near-zero interest rates, this sharp regime shift is presenting a major challenge for consumers, corporates, governments and investors worldwide and has raised volatility across capital markets.
Asian exports under pressure
Slower global growth and weaker demand for durable consumer goods is already significantly impacting Asian exports, particularly products from the technology sector.
The market has moved rapidly to price in a sharp downturn in semiconductor demand over the next few quarters. This has been much to the detriment of Korean and Taiwanese equity markets, both of which are dominated by export-related industries.
The problems in China – the world’s second-largest economy and the biggest in the Asia region – are more home-grown. Ongoing Covid-19 restrictions, and the country’s unwavering commitment to its dynamic zero-Covid policy, are a major dampener on domestic demand, affecting almost all industries, especially those that are more consumer related.
Meanwhile, a deliberate clampdown on leverage in the property development sector has caused a severe liquidity crunch. Subsequently, sales have collapsed, so too new construction activity as buyers defer buying flats and developers hoard cash. With property construction driving more than 20% of economic growth in recent years, this has further depressed economic activity and market earnings. Given these challenges, we think the outlook for growth in China is very poor.
Geopolitical tensions between US and China rising
Asian equities also now have an increased risk premium attached, due to rising geopolitical tensions between the US and China.
The US recently increased restrictions on technology exports to China and identified the country more explicitly as a “Strategic Competitor”.
Meanwhile in China, Xi Jinping was recently confirmed as the country’s leader for a third, five-year term. The Politburo Standing Committee (PSC), an inner sanctum of seven people who make the most important decisions, is now also completely formed from his close allies, with all four incoming members (Li Qiang, Cai Qi, Ding Xuexiang, and Li Xi) having significant professional and personal ties to the president. The broader 24-member Politburo of the Communist Party showed much of the same trend.
These announcements at the 20th Chinese Communist Party’s Congress were received cautiously by international investors. The fear is of an even more interventionist policy stance on the mainland, with less room for market forces and private sector dynamism, reflecting President Xi’s previously stated policy objectives.
All these tensions risk a more marked ‘decoupling’ of the world’s two largest economies going forwards, which could in turn have negative implications for capital flows into Chinese equities.
China’s zero-Covid policy remains a concern
More immediately, there are two key variables that could determine the 2023 outlook for Asian equities. The first concerns China’s response to Covid-19 outbreaks. Any sign that China is willing to relax its dynamic zero-Covid policy is likely to be received very positively by the market given the potential boost to earnings and valuation multiples following the terrible performances seen in the past 18 months.
Our base case expectation is that changes to the policy will be incremental, from the second quarter of 2023 onwards rather than a one-time relaxation. However, this could still be enough to improve sentiment from the current depressed levels and boost economic growth. It would also help support the market in Hong Kong SAR and have a spill-over effect for growth in other regional economies given the close trading links.
The second variable is the extent of future rate hikes required to quell inflation pressures in the West and then the shape of the economic slowdown in the US and the EU, whether it is a soft or hard landing. A peak in the interest rate cycle is also likely to lead to a weakening of the US dollar, which should help liquidity for Asian economies and support equity market valuations. Clearly, the sooner that US inflation and interest rate expectations peak the better the outcome for equity markets globally.
Areas of the market we favour
Despite the near-term challenges, we continue to like global industry leaders in key Asian export sectors, including technology stocks in South Korea and Taiwan that have favourable long-term secular growth drivers. In our view:
The Hong Kong SAR market also offers considerable value and strong businesses that can ride out the current downturn. Financial companies in Hong Kong SAR, Singapore, and parts of Southeast Asia will also be beneficiaries of higher interest rates and offer attractive valuations and yields.
The Indian market also offers some attractive long-term opportunities given the low levels of credit penetration and significant ‘catch-up’ potential for the economy. However, after a very strong performance in the last 2-3 years valuations are now more stretched. Australia also offers attractive buying opportunities and a more defensive profile.
We remain mindful of the political risks and slowing structural growth rates in China. As such, we are focused on a smaller subset of the Chinese market that offers either an attractive risk-reward from any eventual rebound after the easing of Covid-19 restrictions, or companies that are closely aligned with the government’s strategic priorities.