Asian equities: taking stock and looking ahead

How expensive is Asia after 35% rally?

The MSCI Asia ex-Japan Index had gained 35% in 2017, outperforming MSCI World index by 16%. Yet, as Figure 1 shows, many markets in the region continue to be valued much lower than developed markets (DM).

Figure 1: Most Asian equity markets remain cheaper than DM and EM peers

Source: Bloomberg, as of 1 Dec 2017. Indices are unmanaged. An investor cannot invest directly in an index.They are shown for illustrative purposes only. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Past performance is no guarantee of future events. Real results may vary.

Compared to each market’s own history, Asian markets also show more modest valuations. Using cyclically adjusted PE ratios (CAPE), most major Asian equity markets remain on the lower end of historical range and are below their historical averages (Figure 2). For Japan, though current CAPE is relatively high, it is still well below historical average. India and the Philippines are exceptions to this in Asia, while US is the farthest above historical average and is pushing the ceiling of the range. As such, EM Asia offers more upward valuation re-rating potential than the US market.

Figure 2: Cyclically Adjusted Price-Earnings Ratios (CAPE)

Note: CAPE is measured as current price divided by 10yr average earnings. The ranges and averages are based on data from 1997-present. Source: Bloomberg, as of 31 Oct 2017.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future events. Past performance is no guarantee of future events. Real results may vary.

Will the US tax cut take capital out of Asia?

We believe that the net impact would be limited for the following reasons.

• - Much is priced in. US tax cut beneficiaries outperformed losers by 22% since Nov 2016. This suggests that, while positive, the US tax cut is more like the cherry on the icing on a cake, where the cake is an already robust US economy, and the icing is synchronized global growth. US equity returns would still be positive, but more difficult to outperform. As a result, we maintain a neutral (fully allocated) position in US equities.

• - Are taxes the business priority? Businesses investing in China and other parts of Asia are no longer just targeting low labour costs, but increasingly aiming for proximity to the large market demand. For those business that are purely manufacturing in Asia for US final demand, the tax cut could be meaningful, particularly in considering location for new capacity investment. But for those eyeing the fastest consumer growth in the world, tax rates would not be the top consideration, and is unlikely to cause large scale capital outflows. Moreover, the average corporate income tax rate is 22% in Asia, not much higher than the new US rate (Figure 3).

• - The USD remains soft. After a positioning induced rebound in Sep-Oct 2017, the progress and ultimate passage in US tax reform, strong US economic data and a Fed rate hike was unable to lift the USD. This reflects that the US growth and policy backdrop is more in line with the rest of the world, hence difficult to push up the USD. There may still be periodical rebound, but we remain convinced of a weaker USD over the coming 3-5 years. This would be a key support to capital inflows to EM Asia and broader EM, and would suggest equity outperformance (Figure 4). 

• - Global investors remain underweight EM Asia. Even with the stellar performance in 2017, global investors, even EM focused ones, are still heavily underweight North Asia (Figure 5). Active investors may be slow to catch up, but benchmark weights are rising for EM Asia, particularly China. Passive inflows are likely to grow, not just in equities but also in bonds. Together, this is likely to keep portfolio inflows alive for the coming years.

Figure 3: Corporate income tax rates in Asia are not much higher than the potential US rate and lower than global average

Source: KPMG 2017 Corporate Income Tax Rates.

Figure 4: Weaker USD trend would help Asia ex-Japan equities to outperform in coming years

Source: MSCI, Bloomberg, Sentix, as of 17 Nov 2017.

Asia’s cyclical expansion has more to run

After strong performance in the first eight months of this year, Asian markets have remained resilient during periods of USD strength and shaky global risk sentiment. Markets are growing more comfortable with risks like North Korea and central banks unwinding monetary stimulus. Indicators for growth, such as exports and purchasing managers index (PMI), have moderated from the highs seen in early 2017, which may slow down market momentum in first half 2018. But investors should keep in mind that the current expansion is only in its second year since the relatively deep 2015 mid-cycle downturn.

Figure 5: Global equity funds are underweight EM, and EM equity funds still underweight China, there remains potential for additional inflows

Source: EPFR, Citi Research, as of 24 Nov 2017.