Outlook 2018: Asian ex Japan equities
Outlook 2018: Asian ex Japan equities
2017 has been a remarkable year for Asian equities, with total returns for regional markets of c.40% in US dollar terms at the time of writing. These have been the strongest returns since 2009 and among the best five calendar-year returns we have seen in the last 30 years.
Even more remarkable is that a year ago we were faced with huge uncertainties on the political and economic front. President Trump had been elected unexpectedly in the US, huge uncertainty was created by Brexit and in Europe doubts were raised on the future integrity of the European Union (EU) amid a widespread rise in populist parties. A rallying US dollar, traditionally a headwind for Asian markets, and concerns over North Korea capped off the host of worries.
So what lessons can we draw from the fact that equities have so spectacularly ignored these risks and gone on to post new highs across many of the region’s markets?
A "Goldilocks" backdrop
First is that economics trumps politics, and that most political rhetoric fails the tests of real world implementation. In the US we have not had massive stimulus enacted, border adjustment taxes have been abandoned and we have not seen any significant tariff barriers raised.
Meanwhile the continued macro backdrop of moderate economic growth and low inflation globally last year has continued the "Goldilocks" backdrop for equities – not too hot, not too cold … but a slightly warmer overall global growth picture.
The US dollar has also retreated from its earlier highs, which has made it easier for Asian countries to service their debt given their appreciating local currencies. All of this has maintained the constructive "risk on" environment for equities globally, in turn supporting local markets.
Secondly, and perhaps more importantly, earnings trump economics. What has turbo-charged Asian equities this year has been the very strong earnings delivery and consistent upgrades to expectations.
We started 2017 with consensus expectations for c.12% earnings per share (EPS) growth this year. As we write today, however, it looks like we will actually see 22%+ EPS growth, a far more dynamic outcome.
This means that although market indices are up 40%, valuation multiples have not needed to be the prime driver of the expansion, and the prospective 12-month forward price-to-earnings (P/E) ratio of the index today at 13-14x is only modestly above where it was at the start of the year.
What is most notable is how much of the growth is geared not to the traditionally-scrutinised macro economic factors. Instead, it is based on the fortunes of a far lower profile price – that of DRAM and NAND memory – which are key ingredients in building smartphones, laptops, servers and other IT products.
A large portion of this 22% EPS growth is attributable to Korean technology companies, Samsung Electronics and SK Hynix. These two companies alone are likely to make c.US$52 billion earnings in 2017 versus only US$ 22 billion last year, of which c.70% is attributable to profits from their memory divisions.
Rising memory prices have little to do with traditional macroeconomic drivers and everything to do with improved industry-specific supply and demand trends. This is an industry that has consolidated from an irrational market of 10+ players to a more stable, near oligopoly, of only three to four players.
Samsung leads the way with a dominant 40-50% market share. Meanwhile demand has been very strong, helped in particular by the rapid build out of cloud computing data centres by the likes of Amazon, Alibaba, Google and Microsoft.
Similarly, Chinese e-commerce players have also seen very robust earnings growth, notably the triumvirate of Baidu, Alibaba and Tencent. These three companies are collectively likely to report earnings growth of 80%+ year-on-year. As with the Korean tech names, earnings have consistently beaten expectations this year and forecasts have been upgraded materially.
Again, these earnings drivers are geared to more secular industry trends and largely uncorrelated to traditional drivers such as GDP growth or government spending. What we are tapping into is a revolution in the way consumers spend time (more social media/gaming), consume (more e-commerce), transact (more online payments), search for information and in turn how companies interact with their customers. All this creates a tsunami of data in the process for the companies to exploit. As they say, "data is the new oil".
Focused on the future
The third lesson is that although global growth feels better today and earnings growth looks healthy, there is still a very tough operating backdrop for many companies. The average performance for the market disguises some outsized winners that are capturing a disproportionate share of the spoils. So as investors we need to have a laser focus on the future and the rapidly shifting sands in almost all industries.
Looking into 2018 we think that all these lessons remain as relevant as ever. Political uncertainties are, as always, still out there while the Fed’s plans to hike rates and taper its balance sheet still have scope to rattle markets. However, in our equity portfolios we think the focus should remain far more on the bottom up fundamentals of companies than the macro machinations of politicians and central bankers.
Broader secular trends, like the rising adoption of robotics and automation across the manufacturing industry, as well as the coming adoption of electric and autonomous vehicles, will only intensify with time. It is only 10 years since the iPhone was launched, which really represented the starting gun for the explosion in online businesses, and similarly things like machine learning and artificial intelligence are still in their infancy.
Against this backdrop, we continue to be excited about the longer term growth potential for many of the stocks that we own in our Asian equity portfolios. Although markets are being fairly "efficient" such that valuations for the stronger businesses are very full based on today's earnings, we think we are not yet at "bubble" territory and the better companies can grow into their current multiples over the next one to two years.
After such a strong performance in 2017 we should expect more moderate returns on a 12-month view, but this should not deter one from remaining invested with the winners of tomorrow.
The sectors, securities and countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
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