For Asian (ex-Japan) economies, the overall direct impact is limited. Gross exports to the EU account for about a third of GDP, with value added accounting for about 20% of GDP. With the world trade cycles already below trend growth, the Brexit outcome is unlikely to become the sole cause of a global recession. The immediate implications surrounds the extent that central banks coordinate policies to ensure market liquidity while investors revaluate risk premiums that have traditionally been associated with emerging market equities.
In our opinion, the Federal Reserve is more likely to pause its current rate cycle, representing its second change when the US central bank suggested that the economy could withstand two hikes from an earlier expectation of four. Following weaker than expected jobs numbers in May and further USD strengthening from market volatility, the Fed Chairwoman Yellen would probably prefer to maintain interests rates, with the earliest rate hike in December after the national election. The European Central Bank and the Bank of Japan are likely to not only expand its quantitative easing program, but will also have a greater tolerance for interest rates to go further into negative territory.
The accommodative policy backdrop should portend well for emerging markets that have traditionally traded at higher risks premiums relative to developed markets. Following the unexpected Brexit outcome, investors are likely to reevaluate this tenet, particularly as emerging market equities are progressing away from nationalistic policies and towards pro-market reform, with this trend most evident in larger emerging Asian economies and Southeast Asian nations. Brexit not only reflects the opposite but highlights that higher premiums are not justified in the current market environment.
Trade dynamics have shifted as Asian companies have shifted away from concentrated supply chains in preference for diversification that increases foreign content. This would partially explain the limited trade impact as most Asian currencies have depreciated this year against the USD, meaning the terms of trade advantage is offset by rising production costs in local currency terms. The rise of China as both a manufacturing and consumer of end demand means that most of Asian exports remain in the region, with an estimated 51.1% of Asia Ex-Japan (AXJ) exports traded to other AXJ countries, rising from 46.3% only a decade earlier.
Together, liquidity and falling discount spreads should make Asian equities an attractive asset class to hold. Valuations have priced in an unlikely global recession, while most of the region is driven domestically. The immediate beneficiaries in this environment include domestically focused economies, including India and ASEAN particularly Philippines and Indonesia. Southeast Asian economies are supported by low levels of debt, real rates and current account surpluses, which protect the values in local and USD terms. To a certain extent, rising Chinese household consumption should remain resilient, as the bulk of debt is concentrated in the corporate sector while private debt remains low.
Christopher Chu
Assistant Fund Manager - Asia