With the MSCI Asia ex Japan Index down 17.1% in dollar terms in the year to 31 July, investors have turned their backs on Asia-Pacific funds.
According to the Investment Association (IA), in the first half of the year there were net outflows of £490m from the IA Asia Pacific Asia ex Japan sector, as growth markets in general underperformed their more value-orientated counterparts.
Given the threat of surging inflation and the resulting monetary tightening that has taken place, it is little wonder investors have been left scratching their heads about what they should do with their equity weightings.
Though for most of the year risk assets were falling in tandem with bond markets, they defied the deepening economic gloom in July and rallied strongly, with US small caps and tech stocks topping the performance charts.
This has led many investors to question if now is the right time to reintroduce risk assets into their portfolios. Sadly for Asia, much of the region escaped July’s market rally, with the IA Asia Pacific Asia ex Japan sector still down 0.5%. Meanwhile, China’s Hang Seng Index fell by 7.3% during the same time period.
So, what should investors be doing with their Asia exposure? Is it better to stay on the sidelines or have valuations fallen so far as to make it worthy of inclusion?
In this new ‘head to head’ feature, we will hear one manager make the case for an asset class or region, and an asset allocator explain what they are doing within their own portfolios.
This month, Yu Zhang (pictured right), Matthews Asia ex Japan Dividend fund manager, describes what’s happening in Asia and the opportunities therein; while Chris Metcalfe (pictured left), managing director at Iboss, explains how the region fits into his present thinking.
Yu Zhang, manager, Matthews Asia ex Japan Dividend Fund
The biggest driver of volatility in Asian equities this year has been the inflation outlook and a tightening of US monetary policy, with its knock-on effects on the rest of the world.
If we look at the Asia region, the worst performance came from markets with higher sensitivity to US and European economies, including South Korea and Taiwan. Indonesia was the only market in the index that managed to stay flattish during the first six months of the year.
Looking ahead, we are starting to see some signs that a strong uptick in inflation may settle down a little.
This has been reflected in some of the major commodity price corrections, including oil, while the latest CPI figures out of the US also showed a slight easing.
As a result, investors are looking for a change of narrative from the US Fed. A less hawkish policy stance would be beneficial for Asian equities in the second half of this year, in my view.
It is also worth noting that wage inflation in most Asian countries remains quite moderate and commodity cost pressures have also started to soften, allowing more accommodative monetary policy in these countries than their developed market counterparts.
In particular, Chinese fiscal and monetary support combined with more lenient zero-Covid policy implementation recently provided a positive catalyst for investors. It allowed them to refocus on long-term bottom-up corporate fundamentals for investment opportunities in the market.
Admittedly, any major resurgence of Covid and resulting economic weakness in China will prolong the restoration of consumer confidence and delay corporate capital investments.
So where are we finding the best opportunities in this environment and why should investors stick with Asia?
We seek to capture Asia’s growth and deliver attractive returns through capital appreciation and the provision of income. Our total-return approach is focused on blending dividend growth stocks with stable yielding stocks. In times like these, where styles can quickly come in and out of favour, such a flexible approach can help investors navigate markets.
In the first half of the year, cyclical reopening and recovery stocks were relatively resilient. Growth stocks, on the other hand, have severely de-rated and are on much lower valuations compared with six months ago, and this is where we have increasingly found opportunities.
Vietnam is a country we view favourably. Its equity market has gone through a phase of consolidation, which allowed us to pick up some growth companies at potentially attractive valuation multiples. We are also keeping an eye on some areas in southeast Asia, such as Thailand, where tourism is an important part of the economy.
Having recently returned from a research trip, we believe some companies may be well placed to benefit from the Covid re-opening trend, but we are mindful about how much we pay for shares.
There is no doubt Asia is experiencing quite a volatile period, from both an economic and geopolitical point of view. Within the region, however, if you focus on the businesses themselves, the structural growth story in Asia remains very much alive.
As an active investor, I am excited about the prospects for Asian equities as local economies regain their footing and fully re-open after a long pandemic.
Chris Metcalfe, chief investment officer, Iboss
From a portfolio construction standpoint, we look at emerging markets and Asia together. During the past few months, we have added specific China funds by introducing FSSA Greater China and Baillie Gifford China. Additionally, we have added the Stewart Investors Indian Subcontinent Sustainability Fund.
These explicit India and China holdings express our belief that investors need to look at the investable characteristics of these two economic behemoths on their own merits; and not just as part of more broad-based GEM and Asia funds.
A considerable amount of bad news is priced into parts of the Chinese equity market, some of which is justified but some less so.
A central tenet of our bullish case for China is the authorities’ ability to act quickly and decisively when they want to. This is in stark contrast to the US or Europe, where policy implementation is often tortuously slow. From a valuation perspective, MSCI China is trading at 11x P/E versus S&P at 20x P/E, and the US-China valuation gap is at its largest since the global financial crisis.
Our two Chinese funds and, in fact, the whole of the IA China/Greater China sector have little to no correlation with IA Global Equity.
India, while having a higher correlation to regions other than China, still has a relatively low one compared with the investing blocks of the US, UK and Europe, which generally make up the vast majority of UK investor portfolios.
From a diversification point of view, China and India work well. The low correlation is in large part down to the majority of Chinese companies’ revenue (84%) coming from the domestic market. It is similar in India, where about 72% of revenue is generated from its domestic market.
For better or worse, both countries’ markets are moved more by their respective governments’ economic policies than US policy, which dominates market sentiment in most developed markets. As expected, given these two respective markets are idiosyncratic in nature, it’s no surprise they have no appreciable correlation.
Owing to rising incomes and steady wealth creation, living standards in China have improved significantly. Moving beyond the basic necessities, people are willing to pay more and upgrade to premium goods and services. This, in turn, leads to strong growth and higher revenues for Chinese consumer companies.
Chinese companies across the board have been investing in research and development in order to move up the value chain. Improved technological capabilities can lead to better-quality products or more efficient processes, which generally means higher profits. Industry leaders in China are a fraction of the size of their global peers.
Additionally, many Chinese businesses are becoming more competitive in the overseas market and are gaining market share. This suggests Chinese companies have the potential to grow much more prominent over time. Many of these positive factors have become overlooked in the wake of the regulatory crackdown.
Still, since the first announcements on 15 March 2022, when they said they wanted to end the crackdown as soon as possible, there has been a change of rhetoric from the Chinese authorities.
On top of the explicit country holdings, we have exposure to the Asia region via the active Fidelity Asia, Fidelity Asia Pacific Opportunities and the passive L&G Pacific Index Trust. The passive vehicle tracks the FTSE World Asia Pacific (ex Japan) Index and has no exposure to China, which suits us, given our Chinese holdings elsewhere.
The Fidelity Asia Pacific Fund has China as its most significant geographical holding, with India a large underweight, but the main reason we hold the fund is the manager’s high conviction and excellent performance since launch in 2014.
This article first appeared in the September edition of Portfolio Adviser Magazine