Similar risks and similar drivers
The global equity rally in 2017 stemmed not only from subdued geopolitical risks, but also in part from growing evidence of a pickup in world economic trade and a recovery in commodity prices. Coupled with an above-average demand trend in Asia, China’s supply-side reforms to address industrial overcapacity relieved deflationary pressures, while appropriate monetary policies and communicative central banks helped boost risk appetite. By the end of 2017, the MSCI Asia ex Japan returned 38.7% compared with the MSCI World’s rise of 20.1%.
Looking ahead to 2018, while many geopolitical risks still linger, so do last year’s drivers, including synchronised global expansion across the world’s largest economies. Ironically, those most optimistic about world growth are also slightly more negative about risk assets, arguing that the conditions are right for higher interest rates. For global investors, the wild card remains China, where high political capital and a renewed focus on systematic risks have fed concerns that Beijing would tolerate significantly slower growth, renewing market vulnerabilities and anxieties about a hard landing that plagued investors in early 2016.
In our view, these concerns are misplaced, as we believe that expectations are well-founded and not overly optimistic about Chinese and Asian equities, despite last year’s performances. Addressing speculative hazards serves both as a political and market response to changes in the economic and investment landscape. During China’s 19th National Congress, Xi Jinping urged delegates to back an agenda that produces a society supported by a more balanced income distribution and commit more investment to public services, such as environmental protection, healthcare and education. Xi’s stance re-echoed previous comments, including favouring incentives to rebalance domestic consumption drivers for new economic sectors, while reducing overcapacity in older industries.
Political signals face economic reality
For investors, concerns could arise if Beijing’s tolerance were to overlap with an unexpected surge in inflation, thus eroding real growth. Expanding since late 2016, China’s producer price index (PPI) has risen and remained high for longer than anticipated, and increased input prices could push up the consumer price index and force the People’s Bank of China (PBoC) to react aggressively. While we think that the PBoC would prefer a tightening bias to stem speculative behaviour, we do not believe that aggressive tightening would be necessary or effective.
Annual GDP growth is sliding from 8% to 6% and is acting as a balancing political signal. Economically, adding 6% growth in 2018 would expand GDP by around RMB 5 tn, approximately equivalent to earlier in the decade when growth was closer to double-digits. Besides this similarity, a greater proportion of this change is coming from private demand, which is structurally preferred. For inflation, higher industrial prices have been mostly concentrated in a few sectors and are less influential on consumers than the price of food items, such as pork. The link between farmers and the PBoC’s policies is essentially indirect and non-existent.
Near- and long-term implications
Besides improving financial conditions, Beijing’s supply-side reforms illustrate another critical component of systemic risks: the environment. Improving environmental protections not only reinforces Beijing’s commitment to multilateralism, such as the Paris Agreement, but also underlines its commitments to clean energy and subsequent job creation in high-tech areas.
This creates both direct and indirect, as well as near- and medium-term beneficiaries. Advanced information technology and clean energy companies, including electric vehicles and battery makers, are clearly direct beneficiaries. But in the near-term these could face a challenging operating environment, as new investment opportunities and tax breaks also generate competition, making it harder to identify immediate winners, as initial benefits flow to consumers and end users.
In the near term it would perhaps be better to think indirectly and consider the parameters of Beijing’s green initiatives instead. Tougher environmental standards are essentially causing overcapacity in older industrial sectors to continue to be reduced. Consolidation is set to follow but it is likely that larger industrials will keep running, as higher commodity prices are able to support operational cash flows.
Cleaner environment initiatives and advanced technology investment is also diminishing the appeal of emigration to China’s young working population. Avoiding a perilous brain drain not only offsets China’s ageing population profile, but also eases pressure on capital outflows, as savings follow foot traffic. With foreign exchange reserves at more than USD 3 tn, it only requires 5% of China’s population to leave with the annual individual cap of USD 50,000 to deplete all these reserves. Keeping more of China’s young working class relieves this strain on the country’s finances, benefiting banks and financials.
In the medium term, China’s pledge to reduce carbon emissions will coincide with capital market changes. The inclusion of A-share equities in the MSCI Emerging Market index serves as a market catalyst, and also diversifies shareholders and places productivity-enhancing measures at the forefront of equity valuations. This could mark a turning point in our thinking, as companies with listed A-shares are generally more focused on the new economy and service sectors where returns on equity are higher than those in older industries.
Extending the market rally
We take the view that repeating the returns seen in 2017 could be more challenging in 2018, given a pickup in valuations and a better understanding of market dynamics. However, we continue to hold the constructive view that efforts to reduce risks could extend the Asian market rally. Robust earnings in high-growth sectors, such as Asian internet and technology sectors, have made regional equities less vulnerable to periods in which the dollar is strong, given that a rising proportion of profits are coming from the domestic economy and those in neighbouring Asian countries.
We might become more optimistic if Beijing were to make concrete improvements in state-owned enterprises and remove moral hazard dilemmas. Increasing foreign participation and the promotion of policies that reduce the chance of private investments from being crowded out have been more instrumental, but these changes serve as a response to external policy dynamics rather than domestic ones. Addressing this would benefit both Chinese and Asian stocks, as this would support structural shifts in the investment landscape and would negate the discount Asian equities have to developed-market valuations. Political capital in China and across Asia remains high, and the markets would benefit from it, rather than be burdened by it, if some of it were used.
Christopher Chu
Fund Manager - Asia