Earnings across Asia have held up better than many analysts expected following a difficult year for the global economy. Portfolio managers Sharat Shroff, CFA, and Inbok Song discuss how Asia’s economies—and businesses—have found their footing more quickly than those in North America and the Eurozone.
In 2020, there seemed to be a decade of change compressed into a single year. What were some of the notable events?
Sharat Shroff: The pandemic provided markets and companies with a major catalyst and accelerant for change. Before the pandemic, the adoption of e-commerce, software services and digital ways of doing business was previously happening at a slower speed in many parts of Asia, particularly in South Asia. But the pandemic accelerated the move into warp speed, which is creating new opportunities for innovative businesses. Another significant trend we saw was the acceleration of labor reforms in India and Indonesia. Labor reform tends to be a sensitive topic, but some of the changes may ease the cost of doing businesses, and support labor-intensive businesses. And finally, we continue to see further deregulation and liberalization of China’s capital markets including greater openness towards foreign investment, which is providing additional liquidity and support for China’s rapidly growing bond and equity markets. The continued deregulation of capital markets in China may also help increase availability, and lower the cost of capital for enterprises in the country.
You remain sanguine about Asia’s earnings recovery. What drives your optimism?
Inbok Song: In 2020, corporate earnings across Asia dropped much less than analysts initially feared and we believe that earnings may rebound strongly in 2021. Taiwan and South Korea, for example, both contributed significantly to the year-on-year growth in Asia. Both economies did a strong job in containing the pandemic. They are also home to companies that are benefiting from demand for semiconductors. This demand is being catalyzed by 5G, new energy vehicles and penetration of cloud-based services. Another positive trend we see is that companies and management teams were very agile in cutting down costs and reining in capital expenditures. Free cash flow was resilient in the course of 2020.
Sharat Shroff: The impact of the pandemic was disproportionately felt by small and medium-size businesses. In contrast, larger companies tend to dominate the make-up of indexes. The result was a dislocation between the real economy (represented by smaller businesses) and the earnings of companies in the index (represented by larger businesses) in 2020. We believe the economic recovery will start to broaden-out as vaccinations become more widely available. This may support small and mid-sized companies, which are often more geared towards the domestic economy. Notably, small-cap stocks in Asia slightly outperformed large caps in 2020, the first time we have seen that dynamic in the past five years.
What will consumer behavior look like post-pandemic?
Inbok Song: We expect to see a normalization of demand in 2021, where demand may fall in some areas and increase in others. For example, certain IT-related products may normalize from high-growth to a more steady state of growth. On the other hand, demand for travel, dining out and beauty services may naturally increase.
In addition, the adoption of technology is unlocking consumer demand in smaller cities and rural parts of Asia. The emergence of concepts like “group buying” (in which products and services are being offered at significantly reduced prices on the condition that a minimum number of buyers would make the purchase) demonstrate how flexible approaches may catch the attention of consumers in emerging cities in China, for example. These creative uses of technology are creating newer sources of demand for some of the internet companies in the country.
The one aspect of consumer behavior that is unlikely to be altered in our view is the willingness to spend, and to indulge in more premium products. Consumers’ interest in higher-end goods and services is here to stay, in our view, and is being reinforced by the focus on health and safety.
China continued to march forward on its path of capital markets reform in 2020. How significant is this for future economic growth?
Sharat Shroff: When thinking about how China approaches reforming and deregulating its economy, we see some clear patterns at work. Seeking to develop its real economy first, China spent the better part of the last two decades deregulating labor markets and deregulating its natural resources, which makes it easier to set up manufacturing enterprises and lowers the cost of doing business. In recent years, China’s policymakers have been focused on deregulating and liberalizing the capital markets. The interest-rate-setting mechanism is largely market oriented, although policymakers continue to influence the one-year prime rate. We are also seeing progress in the institutionalization and deepening of China’s equity markets. For example, processes that may have artificially delayed companies from filing IPOs in the past are getting relaxed, so new companies don’t need to wait as long before going public. Of equal importance, Chinese policy makers are allowing better inflows and outflows of capital into their equity and fixed income markets, which encourages more foreign participation. These measures may also attract greater household participation in the equity markets, while providing more liquidity and risk management tools to companies and businesses to plan for future growth.
As the U.S. dollar weakened, most Asian currencies gained strength. Why did the Indian rupee decline?
Sharat Shroff: When we look at India’s economy, the fundamentals look solid. Real interest rates (the rates minus inflation) are still decent in India and there has been a solid uptick in foreign reserves. The only conclusion we draw is that India’s central bank is actively managing the currency to attract more manufacturing in India. Increasing manufacturing is a vision that Prime Minister Modi has outlined for the last few years. In order to make India attractive for overseas investors, you not only have to provide a very solid infrastructure set up and a lower cost of business but also an attractive currency so the export sector can flourish. That's one reason the Indian currency has been weak even though there are some decent tailwinds building for India’s economy.
As the global economy recovers, what risks are you monitoring?
Sharat Shroff: Looking ahead, uncertainty remains in terms of the pace of Asia’s economic recovery. As we don’t yet know how quickly vaccines can be distributed, we can’t forecast how quickly daily patterns may return to normal. The strength of the economic recovery in different markets where we invest may not be immediately evident. Also, valuations for Asia ex-Japan equities are above their historic averages. In some areas of the market, we believe investors have already priced in a high level of anticipated future growth. All of these emphasize the importance of investing with a long-term view.
Inbok Song: When thinking of valuations, it is also worth noting that as technology moves to the fore, there’s been a notable shift in the composition of market indexes. When we look back at the MSCI Asia ex-Japan Index five years ago, the biggest weight in the index was financials. Today, the biggest index weight is information technology, followed by consumer discretionary. Both sectors are growing much faster than financials. What’s more, these sectors are often dominated by innovative business models that are capital-light, and offer the prospect of higher profitability. The role of technology may accelerate because many companies, especially in North Asia, continued to invest in structural growth areas throughout the year gone by, even under the very difficult situation of the pandemic. There will continue to be differentiation among businesses that have embraced technology and embrace new ways of engaging with their customers and those that have not. While it is important to emphasize valuation risk, we also continue to be increasingly focused on business-related risks that stem from some of the structural changes discussed above.
What trends are you watching?
Sharat Shroff: We see three important drivers for equity prices—growth, valuation and liquidity. From a growth perspective, we feel convinced that corporate earnings are likely to be strong this year. Asia is on a path to economic recovery and the sheer size of the consumer base in Asia works in its favor. Valuations for Asia ex-Japan equities have risen, so there is less valuation support for the broader market, but we continue to see pockets of opportunity. Over time, the market will begin to discern between companies that can execute well on their vision, and seize market share in an altered business environment.
We are find good liquidity across Asia. Interest rates in Asia are benign, in our view. Rates in Asia never collapsed to the same extent as they did in the U.S. and Europe, so there is lower risk of interest rate shock. Overseas investments coming into Asia may help in lowering the cost of capital. Overall access to capital is also becoming better in much of Asia. Looking at IPOs, for example, there has been quite a few initial public offerings in Asia particularly in China/Hong Kong. We are also starting to see some IPOs also happen in South Asia. The confluence of these drivers will likely support medium to long-term growth across many parts of Asia.
Sharat Shroff
Portfolio Manager
Matthews Asia
Inbok Song
Portfolio Manager
Matthews Asia
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