What ails Asian equities and where to from here?
What ails Asian equities and where to from here?
It has been an inauspicious start to 2022 for many Asian stock markets. Although there have been some bright spots – notably Australia and the smaller ASEAN markets – performance of the overall region has been dominated by the weakness of the Chinese market.
After a torrid year in 2021, with the MSCI China index down by more than 20% in GBP terms, some investors had hoped for calmer seas in 2022. Unfortunately, that has so far proved to be rather optimistic, with the MSCI China index remaining extremely volatile and already down a further 12.5% in GBP terms since the start of 2022 (to 17 March).
There have been a number of negative developments driving this latest bout of market weakness in China; each individually concerning but in aggregate leading some investors to question whether the market has now become “uninvestable”. However, most of these factors were not risks that we were unaware of coming into the year and, in large part, they represent a continuation of the concerns which made 2021 such a difficult year for Chinese equities.
As such, we have not fundamentally changed our opinion and we still see the long-term outlook for Asian equities as attractive, with a diverse selection of structurally attractive companies available across the region at reasonable valuations.
The tragic reports which have emerged during Hong Kong’s fifth (and by far most deadly) wave of Covid-19 have been a stark reminder that the pandemic is by no means over in many parts of the world, something that can be easy to forget from the UK where life is gradually returning to normal.
Many observers had warned last year that such an outcome would be hard to avoid in Hong Kong if the more transmissible Omicron variant of Covid-19 started to spread there, given the age distribution of their unvaccinated population. A quick look at the vaccination rate in the elderly population (who are by far the most at risk of severe outcomes from the disease) would have made clear the risk that Hong Kong’s population faced from a widespread outbreak.
In recent weeks an upsurge in cases across several cities in China, and very strict lockdowns imposed in response, have led investors to extrapolate Hong Kong’s appalling experience to what they expect to see on the mainland.
However, there are two differences one should keep in mind between Hong Kong and the mainland. Firstly, China has a better (though by no means good enough) vaccination rate amongst the elderly.
Secondly, China is more willing and able to impose extremely strict lockdowns in response to outbreaks, increasing the chances (though by no means guaranteeing) that they will avoid a spiralling wave of community transmissions. However, we know by now that these measures have a significant drag on the economy where they are imposed – not just for local incomes and consumption, but by disrupting supply chains across the country and indeed the world.
The prospect of more lockdowns throughout the year, which to us look inevitable to protect a population with next to no natural immunity and with vaccines of unknown efficacy against Omicron, is a poor one for economic growth in China.
Broader economic concerns
Unfortunately, the Chinese economy was not in rude health heading into the year, even before the latest Covid-induced headwinds. This was a key factor weakening market sentiment in 2021, in particular the second half which saw slumping retail sales and a deflating property sector as developers such as Evergrande ran aground, and credit growth slowed materially.
Market hopes of significantly looser policy have been disappointed, with stimulus moves so far being modest and measured as the government remains wary of reigniting a debt cycle or inflating asset price bubbles.
The key positive driver for the economy in recent quarters has been strong global demand for manufactured goods, boosting Chinese exports, leading to strong manufacturing fixed asset investment growth.
This growth support from exports is now likely to fade as the rest of the world moves away from the so-called “Covid economy” and spends more on services again (and consequently less on goods). Risks to global growth have also clearly risen recently from the conflict in Ukraine and the subsequent spike in energy prices, which I discuss further below.
It seems clear, therefore, that higher Chinese growth will have to be driven by domestic demand this year. Which brings us to…
Barrels of ink were expended last year talking about the regulatory environment in China and the impact on the stock market, so there is little point repeating it all again here. With a weaker economy, there may be even more pressure for “burden-sharing” by profitable companies. We have already seen this happen this year, for example in the requests for internet platforms to cut the food delivery fees they charge restaurants hit by lockdowns.
However, the government may also be starting to recognise that the relentless regulatory onslaught of the last 15 months has hurt private sector confidence and investment, and hence economic growth. The market’s reaction to mollifying (albeit vague) announcements by the government on 16 March suggests that sentiment on the hardest-hit stocks can swing rapidly on any change in the regulatory stance.
Without a crystal ball (or rather a source close to the powers that be), there is little insight we can add on the timing or extent of such regulatory changes, however, as they are driven by political considerations above all else.
Another regulatory headwind this year, although this time blowing in from the US, was the renewed focus on Chinese companies' American Depository Receipts (ADRs) being forced to delist from New York due to non-compliance with the Holding Foreign Companies Accountable Act (“HFCAA”) – broadly a requirement to share detailed accounting and audit data from China with US authorities.
This was already a well-known risk, with the HFCAA having become law in December 2020 and delistings unlikely before 2024. However, the move this month by the Securities and Exchange Commission (SEC) to name five Chinese companies listed in New York which face this threat brought these concerns back to the forefront of investors’ minds. Separately, there have been more Chinese companies added this year to US lists which restrict their access to key equipment or technologies, particularly in the biotechnology sector.
Although it is certainly possible that a negotiated solution can be found between the Chinese and US authorities, and recent announcements suggest China is still supportive of its companies having overseas listings, it is important to remember the context is a broader trend towards financial and economic “decoupling” between China and the US. This is something which both governments, for their own reasons, have not discouraged. It is this context which has also driven concerns that potential sanctions could be imposed on China, should they undermine western efforts to isolate Russia over its invasion of Ukraine
As with global equity markets, higher risk premiums as a result of the war in Ukraine have hit stock markets in Asia. However, the most direct impact of the conflict on the region has so far been through higher energy prices. Higher prices will weaken global real incomes and hence consumption, hurting demand for Asian products. China, like many Asian countries, is a net energy importer and so will also suffer from rising prices.
Higher inflation will certainly act as a headwind for Asian countries, but the region at least entered the year with inflation generally at lower levels compared to the US. Although painful for certain countries’ external accounts, and many companies’ input costs, volatility in commodity prices is a risk investors are used to dealing with in Asia and creates winners as well as losers.
What are the implications for markets?
Putting all of the above together, what is the outlook for markets? The most obvious point is that Asian market valuations look much less frothy than they did a year ago, particularly relative to global equities.
Of course, valuations scarcely matter if you believe China has become an “uninvestable” market. We don’t believe that – there are still plenty of excellent companies to invest in in China, across A-shares, H-shares and overseas, with strong management and resilient business models.
As investors, we buy companies, not countries. Although we are mindful of the impact political and macroeconomic factors can have on equities and returns, we are bottom-up stock-pickers first and foremost. We do not try to pick companies which will do well based purely on a particular macro environment which we have forecast; rather we try to pick well-managed companies which have structural advantages allowing them to survive (and hopefully thrive) in as wide a range of external conditions as possible.
Although we are of course looking for opportunities thrown up in the market volatility, we do so cautiously given the myriad challenges facing companies operating in China. We seek companies with strong governance and the ability to earn returns sustainably above their cost of capital.
Fortunately, Asia offers no shortage of such stocks, across many geographies and industries, some of which have been caught up in the market weakness offering good buying opportunities.
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