Asia: Pivot Required

By Henry H. McVey Oct 20, 2016

I recently joined my colleague Frances Lim on a whirlwind tour of the Asian region. In an attempt to refresh our top-down view of Asia, we visited a variety of cities and met with a variety of folks across both the private and public sector. To state the obvious: there is certainly no 'one' Asia, as the region includes both large developed markets (like Japan, Korea and Australia) as well as large emerging economies (like India, China and Indonesia). Not surprisingly, we came away with a broad variety of what we believe are actionable investment conclusions for the macro and asset community:

• Emerging market (EM) equities, including Asia, may be finally bottoming. After 72 months of underperformance, our base case is now that EM is in the process of bottoming. We see several factors at work. For starters, we believe that the influence of local currency trends is going from being a major negative to a modest positive. Second, there is no scope for easing, which is good for both offensive and defensive reasons. Third, most global investors are now underweight EM as an asset class. Our bottom line: we think that earnings are bottoming, ownership of EM is well below benchmark, and valuations are much more attractive.
• Larger consumer economies across emerging markets, Indonesia in particular, are likely to see expanded valuations in the near-term. In today's post-Brexit environment, we are of the mindset that investors will continue to shun globalization stories in favor of domestic consumption stories, higher value added services in particular. No doubt, the U.S. - with 68% of its economy linked to consumption - should prosper. However, several EM countries should fare well too.
• Right now in Asia, we are most inclined to sell simplicity and buy complexity. While we remain constructive on long-term consumption trends, many companies that target this area of the Asian economy now appear expensive. In particular, we think that consumer stories linked to maturing penetration stories appear overpriced relative to their forward looking growth rates. By comparison, we actually think that there is currently a major opportunity to help Asian conglomerates that have over-diversified across industries and / or over-estimated the opportunity within an industry. In our view, complexity of story appears cheap on a relative basis in today's low rate, slower growth environment.
• Some of the best opportunities in Asia may not actually be in Asia these days. Since we began visiting the region in 1995, the bull case on Asia has always been that China would boost GDP-per-capita across the region for an extended period of time. What is actually unfolding today, however, is quite different. For starters, China's growth is slowing, particularly on a nominal basis. As such, many executives in Asia are now looking for new markets to bolster growth across their existing product suite. In addition, many EM corporate executives with whom we speak believe that there are best practices they can acquire overseas and bring back to their domestic markets. As such, we think that there is an emerging opportunity for global private equity firms and certain multinationals, to partner with Asian companies, Chinese ones in particular, looking to expand abroad.
• India: We favor credit over equities in a solid Prime Minister Narendra Modi-driven macro environment. We left India with two important takeaways. First, we think that, while the Modi euphoria has abated since our last visit, the broad consensus is that the current government is steadily making solid progress. Second, similar to our last trip, we think that, all else being equal, debt appears more attractive than equities. In particular, we continue to see a burgeoning opportunity across private credit, and we do wonder why more of our clients are not looking towards the private credit markets.
• Regional risks include valuations in China's private TMT sector as well as overreach concerns surrounding the Bank of Japan. After a long series of high level meetings across both the public and private sector, we came away thinking about three risks that may not be fully appreciated by investors. First, it is clear to us that the private growth investing in China got overheated, suggesting lower valuations are now in story for many private, IPO-seeking companies. Second, there was again concern from the 'Authorities' with whom we spoke that the Chinese government is still not willing to make the hard changes required to structurally improve its outlook. Third, there is growing concern that Japan's monetary policy may ultimately backfire.

In conclusion, this recent trip to Asia was probably the most interesting one that I have had in years. Why? Because beyond a rapidly changing macro outlook, the tools required to be a successful investor in Asia are changing too. Overall, though, we left Asia with the sense that - in today's low rate, low growth environment that defines the global economy in which we live - both public equities and parts of private credit are likely to deliver above average returns over the next three to five years for global investors, particularly those with broad mandates and multiple touch points in the region.

If we are right, then we are in the early innings of a notable change in flows and performance that global investors may want to incorporate into their thinking.

To read Henry McVey's full report, clickhere.