Mike Kerley, Asian income equities portfolio manager, shares his views on the latest developments in Asia and discusses the investment implications from an income point of view.
- Falling interest rates favour high yield stocks as when the dust settles the need for income for an ageing global population in a low or negative interest rate environment should prevail.
- In Mike’s view, growth-orientated stocks, which previously had been dismissed on valuation grounds, are looking attractive, particularly in the consumer and technology sectors.
- Although earnings will come under pressure in Asia, especially in the short term, dividends may prove more resilient.
In recent weeks the world has endured an unprecedented increase in volatility with market moves reminiscent of the Global Financial Crisis in 2008. The COVID-19 coronavirus started as an Asian problem with the potential to disrupt supply chains. However, it has now gone global, with draconian measures being implemented across the world to contain its spread and is seriously impacting demand for many goods and services. The fear that the slowdown in consumption could tip the world into recession has prompted central banks to cut interest rates aggressively. But the feeling is that monetary stimulus alone will not be sufficient and that a more progressive fiscal response is needed. The significant rally in government bonds is reflective of both risk aversion and the view that global growth prospects are seriously impaired.
Oil and the energy sector
The turmoil has been exasperated by the significant sell-off in oil prices. The breakdown in talks between Saudi Arabia and Russia has led the former to threaten to increase production, pushing the oil price considerably lower. Although this is positive for consumers in general and countries that are net importers of oil, it has drawn attention to the debt levels in the energy sector, especially in the US. Given currently much lower oil prices, a number of energy companies may no longer be viable. It is no surprise therefore that high yield credit spreads in the US have risen while the increase in volatility has raised concerns in this relatively illiquid sector.
It remains difficult to ascertain the impact of coronavirus on global growth until new levels of infections have peaked. Experts seem to think that the virus will run its course as temperatures rise towards the middle of the year but the impact between now and then is unclear. It is fair to say that the ‘V’- shaped recovery that investors initially expected will not materialise and even a recovery in the second half of 2020 is not a certainty.
The aggressive containment measures undertaken by China appeared to have worked and at the time of writing there is a significant drop in daily new coronavirus cases. A similar trend is also evident in South Korea and without wanting to be complacent it appears that Asia is now over the worst. Additionally, targeted measures to boost recovery together with cuts in interest rates is allowing manufacturing production in some sectors to gradually return to normal. However, movement between countries will remain subdued and the tourism and transportation sectors will struggle for some time to come.
Expectations and positioning
Although it is difficult to quantify the impact on global growth there are few things that are easier to foresee:
Interest rates will most likely continue to fall and remain low for some time
- This favours high yield stocks as when the dust settles the need for income for an ageing global population in a low or negative interest rate environment shouldl prevail. It should also be positive for equity income especially if the pressure on high yield bond markets continues to build.
- Lower interest rates are also positive for asset prices, though banks will come under pressure from narrower interest margins, while small and medium-sized enterprises will likely struggle with their loans under a global cash crunch. Banks could also come under pressure to perform ‘national service’ (a directive from the government) by extending credit terms which may not always be viable.
- With this in mind, we have reduced our holdings to banks in Australia, Singapore and South Korea. We have increased exposure to Singapore real estate investment trusts (REITS) and have also added to positions in telecoms companies in South Korea and also Australia.
China appears to have the most flexibility to face the challenges in the months ahead
- Government policies in China are focused on adding liquidity to reduce the pressure on corporate cash flow while emphasis has been placed on fast tracking infrastructure projects. Further supportive measures for the property sector are probable.
- We have increased the weighting in China to around 25% by adding to positions in property, construction, materials, consumer and financial services. But we remain cautious on the banks’ likelihood for national service.
- We also remain constructive on materials mainly driven by the recovery in China.
Market volatility is presenting investment opportunities
- We think growth-orientated stocks, which previously had been dismissed on valuation grounds are looking attractive, particularly in consumer and technology- related areas.
- Although earnings will come under pressure in Asia, especially in the short term, we expect dividends to prove more resilient. There will be some companies cutting dividends in this environment but in many cases dividends from companies that we hold are backed by relatively low payout ratios, strong cash flows and resilient balance sheets.
Primarily from a valuation viewpoint we remain cautiously optimistic on the outlook for Asian equities. In our view current valuations are attractive versus global markets, in particular following the recent bout of volatility. In the short term, markets await some positive news on the COVID-19 virus as worsening economic data across the globe concerns investors. In addition, policy action by global central banks such as the US Federal Reserve cutting rates twice in the space of two weeks and elections uncertainty will also have the potential to impact investor sentiment, alongside geopolitical tension. We will use the increase in volatility to add to positions in favoured sectors and stocks at more attractive prices with a focus on domestic sectors, which can be less impacted by broader macroeconomic factors.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment,
Illiquid sector: a sector where stocks or other securities cannot be easily bought or sold in the market because there are fewer willing buyers and sellers in the market.
High yield credit spreads: the difference in the yield of lower quality corporate bonds (sub-investment grade) over equivalent government bonds
REITs: an investment vehicle that invests in real estate, through direct ownership of property assets, property shares or mortgages.
Payout ratio: the percentage of earnings distributed to shareholders in the form of dividends in a year.
Balance sheet: a financial statement that summarises a company's assets, liabilities and shareholders' equity at a particular point in time.
V-shaped recovery: a rapid economic decline followed by a short trough before a rapid recovery in the economy
Interest margin: the difference between the interest a bank pays on deposits and the interest it charges on loans.