APAC investment outlook: Patience needed

October 03, 2022 08:52
More lockdowns this year are really hurting China consumers' confidence, wage growth is low, and spending is weak. Photo: Reuters

Global markets rallied hard from the lows in June on hopes of a Federal Reserve (the Fed) pivot before correcting in mid-August. The correction was mainly driven by the Federal Reserve’s message during the Jackson Hole meeting. Inflation is much more stubborn than they thought, and they will be much more hawkish, U.S. rates will go higher and for longer and no pivot on the horizon. The August U.S. Consumer Price Index (CPI) confirmed, despite lower gas prices that inflation is stickier than previously thought, particularly in areas such as rent. The market is now pricing in 75 basis points hike for the September meeting. The dollar continues its strength which is a real headwind for Asian markets.

Similarly in Europe, inflation levels have far exceeded its central bank’s targets. The risk of a further deterioration of energy supply threatens higher inflation ahead. The European Central Bank (ECB) lifted its interest rates by an unprecedented 75 basis points in its September meeting to curb inflation. Exceedingly high inflation in Europe and the risk of de-anchoring of inflation expectation are expected to force the ECB to raise interest rates more aggressively. The market is forecasting another unprecedented 75 basis points hike in October.

Comparatively, the inflationary situation in Asia looks relatively moderate. Asian inflation is not demand driven, but rather supply driven and the labour market in contrast is weak, especially in China. The unemployment rate among China’s youth aged between 16 and 24 surged to 19.9% in the August data release. This is because unlike in Developed economies, there has been limited fiscal spending within Asia during the Covid-19 pandemic. The debt burden in Asia has been borne by the private sector and households, not the governments. Household balance sheets have not been bolstered by government pay-outs. Most Asian countries are not totally free of Covid measures yet and demand has therefore been weak. However, the demand profile could change next year when Asian economies are fully opened.

Despite lower inflation, most central banks have hiked rates early but not in the same degree as the West. In fact, the two largest central banks in Asia, the Bank of Japan (BoJ) and the People’s Bank of China (PBoC) are maintaining their neutral monetary policy stance to support the economy. The Interest rate differential relative to the U.S., lower growth and higher oil prices have put a lot of pressure on the Japanese Yen which has moved from 128 to 145 since May. Covid lockdowns and lower than expected growth forecast have also resulted in weakness of the Chinese Yuan. The PBoC has been working to dampen the effect but the Chinese Yuan recently has broken the 7 level.

APAC Investment Outlook

Asian markets are still facing many headwinds. A weaker economy, particularly China, higher U.S. rates, and a strong dollar. In the coming months, volatility and risk premium should remain elevated as U.S. rates go higher and growth slows.

Asian equities, particularly North Asia, continue to underperform. Will this change? Asian equities are now reasonably valued but there are risks of earnings downgrades. In an environment where global equities are expected to generate only modest returns over the next year with increased volatility relative to the past, Asian equities have the potential for higher returns in the medium term. However, it is still too early to call an overweight on Asian equities relative to developed markets. The main constraint to Asian equities’ performance is the Chinese market. When we see an improvement in the Chinese economy and the Chinese equity market then Asian equities should outperform global equities. Until then patience is needed.

China’s equities have been negatively impacted by China’s zero Covid policy. Although China managed to recover quickly despite its Zero Covid policy in 2020, more lockdowns this year are really hurting consumer confidence, wage growth is low, and spending is weak. Another area of concern has been the Chinese property market. In some cases, disappointed homebuyers stopped making mortgage payments on units in unfinished projects. This came as developers struggle with snowballing debts and rising default risk. The central government is taking more active role to help selected developers on completing unfinished project. However, the Chinese government could come up with more sustainable policy to address the deep-rooted issues and weak sentiment in the housing market.

Regulatory risks are becoming yesterday’s news and the Chinese equity market has largely priced in the regulatory risks within the internet space. Regulation changes from the shift in policy priorities towards common prosperity have been announced and are mostly in the implementation phase. That said, the Chinese internet sector is still a consumer play and is negatively impacted by the weak consumer sentiment within China. Therefore, a recovery in consumption is needed to lower the risk premium in the internet sector. In addition, other new economy areas have been held back by President Biden’s executive order on U.S. Chips Act and Biotechnology and Biomanufacturing Innovation.

The Chinese equity market has largely priced in the negative economic environment and are over-sold, so downside could be limited. Comparatively, the U.S. market is over-priced, and outlook is weakening. Global risk off and low positioning coupled with sufficient policies support provided by the Chinese government, could see Chinese equities outperform tactically. But what could be the catalyst?

In the next couple of months, the Chinese equity outlook could gradually improve, especially when the 20th People’s Party Congress concludes in October, and the focus of the Chinese government may move from politics to economic. The four key factors that could drive the Chinese equity market are (1) an announcement of a pathway for ending of zero covid policy, (2) more support for the housing market, (3) easing of geopolitical tension, and (4) positive news on Chinese American Depository Receipts (ADRs) delisting risk.

Within the rest of North Asia, the outlook for Korean and Taiwanese equities is challenging on the back of peak recovery within the U.S. Demand for technology and semiconductors is weakening as demand switches from goods to services and lower global growth.

Japanese equities offer good value with robust earnings. However, selectivity is key. Japanese equities market has been negatively impacted by the weaker yen. Interestingly from an earnings profit basis, the impact of weaker yen has not been as great as observed in the past. The increasing yield differential between the U.S. and Japan is clearly negative for the Yen. The Yen should remain weak as the risk of a sudden turnaround of BoJ monetary policy is low this year. In addition, Japan struggles with weak consumer sentiment and a lack of domestic demand. Consumer sentiment remains almost as weak as the Global Financial Crisis in 2008. The service industries including the hospitality, dining and transportation sectors remain relatively weaker. These sectors should improve as the country eases covid restrictions and borders controls.

High uncertainty over costs of an open-ended zero Covid strategy and divergence in PBoC’s accommodative monetary policies versus the Fed’s growing hawkish policies continue to weigh on the Chinese Yuan. The Chinese Yuan has weakened against the dollar significantly since mid-April due to Covid-19 outbreak and renewed strict lockdown measures in major cities. Looking ahead, Chinese Yuan is likely to follow the trend of other Asian currencies and depreciates slowly against a strong dollar. If China continues to post strong trade surplus and control capital outflows, the Chinese Yuan depreciation pressure should not be significant. In addition, improving Covid and growth outlook in later part of 2022 should provide some support for the Chinese Yuan.

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Chief Investment Officer APAC and Head of Emerging Market Equities at DWS