Mike Kerley, Asian income equities portfolio manager, provides the reasons why he maintains an optimistic outlook for Asia and its prospects for delivering income to investors.
- Improving outlook for China is likely to benefit the region
- The trend for corporate earnings upgrades in Asia looks positive moving into the new year
- Should the Asian economies improve, the drivers of performance are likely to switch to more value-orientated sectors, which would better suit the team’s Asian income equities positioning
- The team’s expectation for dividend growth to exceed earnings growth remains
Despite Asia Pacific ex Japan markets rising almost 20% in US dollar terms in 20191 and geopolitical and trade risks still elevated, we believe there are reasons to be optimistic about the year ahead.
China may provide regional support
The optimism is based on improvements in China and the positive impact this will have on the rest of the region. Unlike previous cycles where the Chinese response to domestic or external challenges has resulted in a splurge on debt-funded spending leading to overcapacity, especially in the state sector, and weaker corporate balance sheets, the response though 2019 has been much more pragmatic.
Cuts in interest rates and bank reserve requirements have increased liquidity and the access to credit, while tax cuts and state-owned enterprise reforms have stabilised consumption and increased the productivity of the most inefficient parts of the economy. These measures were deemed insufficient to offset the trade dispute with the US through most of 2019, but recent manufacturing and service PMIs (purchasing managers’ indices) are suggesting that the worst is now behind us and economic expansion is possible in the quarters ahead. The recent outbreak of the coronavirus may well delay these trends and at the date of writing it is difficult to gauge how long it will take and what impact it will have. For now, this appears more like a postponement rather than a cancellation of recovery, and we expect these positive trends to resume at some point.
Expectations for strong earnings growth persist
The earnings outlook for the region is crucial as history suggests that Asia and emerging markets only tend to outperform developed markets when earnings growth is high and/or superior (see chart 1). Expectations for 2019 were high but continual downgrades left earnings growth for the region down on a year earlier resulting in Asia lagging other regions, the US in particular.
The outlook for 2020, however, is more encouraging, with earnings growth expected to be north of 10%, ahead of Europe, Japan and the US.2 More importantly, the trend is looking positive with upgrades through the last quarter of 2019.
Chart 1: Asia and emerging markets tend to outperform developed markets when earnings growth is high and/or superior
Source: Janus Henderson Investors, Bloomberg, as at 31 December 2019. Note: EPS = earnings per share. Data provided in USD terms. Past performance is not a guide to future performance.
The strong price performance and weak earnings have left current valuations for Asian companies above long-term averages at around 14x 12-month forward earnings per share (EPS) (chart 2). It is imperative that Asian companies deliver or beat analysts’ expectations to justify these valuations – we think they do, however, remain attractive relative to other regions where price-to-earnings multiples are higher and growth expectations are lower.
Chart 2: Asian equities valuations currently above long-term average
Source: Janus Henderson Investors, Factset. As at 31 December 2019. EPS = earnings per share. 12-month forward EPS monthly data from 29 January 2010 to 31 December 2019. Past performance is not a guide to future performance.
How we are positioned for the year ahead
An improvement in economic prospects across the region could materially impact the drivers of stock market performance. Growth has outperformed value over the last ten years as a relatively weak global environment has led to investors paying up for quality growth stocks, while performance has been concentrated in sectors such as internet, consumer staples and healthcare.
If economic momentum improves we expect more cyclical sectors to perform better, which is why we have increased our allocation to materials, semiconductors, property and industrials. At the country level, this has led to a greater allocation to North Asia compared to South Asia with positions in China, Taiwan and Korea prominent, while weightings in Australia are dominated by positions in select miners and other companies that may benefit from a pick-up in the region.
While the earnings position in most of Asia appears to be improving, this cannot be said of India where momentum continues to fade. The market underperformed the rest of the region in 2019 but not by enough to reflect the deterioration in fundamentals; as a consequence we saw India’s valuation premium to the rest of Asia rise.
Historically, the Indian market (MSCI India Index) has not generated a positive return over one year when starting at a P/E ratio above 19x, which is what the market is valued at currently3, hence we retain a zero weighting.
Considering the risks
With tensions between the US and China running high, there continues to be a risk of a deterioration in relations and the possibility of a resumption of the tariff war, has proved damaging to both countries. We will also have to see how the coronavirus outbreak plays out and its implications on not only China, but also global trade. In addition, the volatile situation in the Middle East could have a material impact on the oil price, which would be detrimental to most Asian countries as, with the exception of Malaysia, they are all net importers of oil.
Banking on a region with attractive growth potential
We believe the outlook for dividends in Asia Pacific remains robust as we anticipate dividend growth to exceed earnings growth in the years ahead. Asian companies have the potential to produce ever-increasing levels of cash flow and with dividend payout ratios still below 30% in some Asian markets, we think there is ample room for dividend uplift or even special dividends. The share buyback culture, which is so prominent in the US has thankfully not made its way to Asia in any meaningful way, potentially providing many opportunities for dividend investors to reap the benefits in the years ahead.
1 Source: Refinitiv Datastream. MSCI AC Asia Pacific ex Japan Index total returns in USD terms, 12 months to 31 December 2019. Past performance is not a guide to future performance.
2 Source: Factset, 12-month forward EPS as at 31 December 2019 for MSCI Asia Pacific ex Japan, MSCI Europe, MSCI Japan, MSCI USA indices. Estimated data may vary and are not guaranteed.
3 Source: BofA Global Research and Bloomberg as at 31 December 2019. Starting price-to-earnings ratio (as at 31 December) and subsequent one-year calendar return for MSCI India Index since inception. Past performance is not a guide to future performance.
Balance sheet: a financial statement that summarises a company's assets, liabilities and shareholders' equity at a point in time. It provides investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
PMI: Purchasing Managers' Index is an early indicator of the economic health of the manufacturing sector within an economy. The index is based on indicators such as new orders, inventory levels, production, supplier deliveries and the employment environment.
Bank reserve requirement: a regulatory requirement that determines the minimum amount of cash reserves that a bank must hold.
EPS = earnings per share: the portion of a company’s profit attributable to each share in the company. It is one of the most popular ways for investors to assess a company’s profitability.
Cyclical stocks: shares of companies that sell discretionary consumer items, such as cars, or industries highly sensitive to changes in the economy, such as miners. Cyclical stocks tend to be strongly affected by ups and downs in the overall economy.
Valuation premium: when the market price of a stock/company is thought to be more than its underlying value, it is said to be ‘trading at a premium’ or have a valuation premium.
Dividend payout ratio: the percentage of earnings distributed to shareholders in the form of dividends in a year.
Share buyback/repurchase: a company purchasing its own shares, usually to return surplus cash to its shareholders.
Price-to-earnings (P/E) ratio: a popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.