Cyclical tailwinds vs. secular headwinds in Asia ex-Japan equities
Dr. Jasslyn Yeo
Corporate profitability in Asia ex-Japan has been trending lower since 2011 amid both secular and cyclical headwinds. For 2020, we expect cyclical headwinds to turn into moderate tailwinds as the global cycle starts to inflect upwards, and for Asia ex-Japan cyclicals to outperform defensives. However, with secular headwinds still persisting, we continue to favor Asia ex-Japan companies that have higher quality growth potential and profitability. We believe Asia ex-Japan companies that can grow, adapt and innovate their business models to today’s rapidly changing environment will ultimately be able to generate profitability and deliver long-run outperformance.
HOW PROFITABLE ARE ASIA EX-JAPAN COMPANIES?
Corporate profitability in Asia ex-Japan has been trending lower over the past eight years. Return on equity (ROE) has fallen from 16% in 2011 to 10% today. After sharply rebounding post the global financial crisis (GFC), Asia ex-Japan ROE entered into a multi-year decline in 2011. In late 2016, ROE staged a moderate recovery as synchronized global growth and reflation took hold, but that proved fleeting. Asia ex-Japan ROE turned downward again in late 2018 amid softening economic growth momentum and escalating U.S.-China trade tensions. Currently, at 10%, Asia ex-Japan ROE is back near its post-GFC low (Exhibit 1).
Asia ex-Japan ROE has been declining steadily since 2011
EXHIBIT 1: ASIA EX-JAPAN EQUITY ROE
RETURN ON EQUITY
Delving deeper using the Dupont equation,1 we find that Asia ex-Japan corporate profitability has fallen mainly because of weaker net profit margin and slower asset turnover. Meanwhile, financial leverage has remained relatively stable (Exhibit 2).
Asia ex-Japan’s eight-year ROE decline can be attributed to weaker net profit margin and slower asset turnover
EXHIBIT 2: DUPONT EQUATION: CONTRIBUTION TO THE CHANGE IN ASIA EX-JAPAN ROE
Net profit margin and asset turnover have come under pressure in recent years largely due to a more difficult revenue environment (Exhibit 3). Asia ex-Japan exporters, in particular, have struggled to grow revenue against a weaker nominal GDP growth backdrop in China and globally (Exhibit 4).
Asia ex-Japan companies’ net profit margin and asset turnover have been falling in a more challenging revenue environment
EXHIBIT 3: ASIA EX-JAPAN NET PROFIT MARGIN AND ASSET TURNOVER
Asia ex-Japan revenue growth has been slowing in a lower nominal growth environment
EXHIBIT 4: ASIA EX-JAPAN SALES REVENUE AND ASIA EX-JAPAN NOMINAL GDP
Both secular and cyclical forces have played a part in driving down both volume and prices. Net exports have become a smaller engine of Asia ex-Japan real GDP growth as global trade activity has moderated over the past decade. More recently, net export volumes have taken a bigger hit amid the global industrial and tech cycle downturn, as well as persistent U.S.-China trade tensions. Unlike past slowdowns in 2011–12 and 2015–16, this time around, large scale, credit-fueled stimulus in China has also been conspicuously absent, given the Chinese government’s shift in policy focus to financial deleveraging and debt stabilization.
Inflation has also been falling in Asia ex-Japan, contributing to lower nominal GDP growth. One key driver of lower inflation has been the steady decline in commodity prices. China’s economic rebalancing from manufacturing-based to services-based, and excess capacity in manufacturing after years of resource misallocation by the state-owned enterprises (SOEs) and local government funding vehicles (LGFVs), has inevitably resulted in lower commodity demand and prices.
On a corporate level, lower inflation has generally led to weaker pricing power for Asia ex-Japan companies. Pricing power has suffered setbacks on multiple fronts. In addition to excess capacity in sectors including industrials and commodities, competition from Chinese companies has intensified under China’s import substitution policy (i.e. Made in China 2025). Technological change has also disrupted many traditional business models.
The reality is that many Asia ex-Japan companies have not adapted quickly enough to the increasingly challenging revenue landscape, leading margin compression to become the norm. At the same time, unit labor costs, especially in China, have been rising, further squeezing margins. Operating efficiency has also fallen as a result, as reflected by lower asset turnover. Recent capex discipline, however, has helped to slow fixed asset formation and stabilize asset turnover.
2020 outlook: Cyclical headwinds may turn into moderate tailwinds but secular challenges persist
There are early signs that the global macro cycle may be reaching a turning point in 2020. Leading economic indicators such as global manufacturing PMIs have started to inflect upwards, new export orders have started to pick up and global semiconductor sales have bottomed. The U.S. and China have also signed a “phase one” trade deal.
Our base case is for global growth to moderately reaccelerate in 2020, with trade tensions easing and monetary support from earlier policy rate cuts kicking in. Central banks are likely to keep monetary policy accommodative and governments are expected to provide more fiscal stimulus to support growth (for example, Japan recently announced a JPY 25 trillion stimulus package). While upside risks to growth remain limited, downside risks to growth have fallen markedly. Accordingly, late-cycle expansion looks set to extend for another year and the U.S. economy looks likely to avoid a recession.
Against this improved macro backdrop, we expect Asia ex-Japan profitability to moderately recover, with some operational leverage coming into effect. While there may be some downgrades to this fiscal year’s consensus expectations for MSCI AC Asia ex-Japan earnings growth (currently at 14%), we believe that the worst of Asia ex-Japan’s earnings slowdown is likely over. Earnings revisions are improving as the pace of downgrades has started to slow (Exhibit 5).
We have recently upgraded Asia ex-Japan equities to a positive stance in our tactical asset allocation. Along with expectations for improved earnings growth, we see the moderating U.S. dollar and MSCI Asia ex-Japan’s attractive relative valuation vs. the region’s bonds supportive of a further rally in Asia ex-Japan equities this year.
Asia ex-Japan earnings revisions have started to turn up
EXHIBIT 5: ASIA EX-JAPAN EARNINGS REVISIONS
EARNINGS REVISIONs RATIO
In particular, we expect Asia ex-Japan cyclicals to outperform defensives as the global cycle turns upward (Exhibit 6). Cyclicals have already started to post gains vs. defensives even before OECD leading economic indicators have turned up. However, we still see potential for further rotation from defensives into cyclicals and for Asia ex-Japan cyclicals/defensives outperformance to continue. This is as we believe the growth recovery story is not yet fully priced in and bond yields will be moving moderately higher this year.
Asia ex-Japan cyclicals tend to outperform defensives when the global cycle inflects upward
EXHIBIT 6: ASIA EX-JAPAN CYCLICALS/DEFENSIVES RETURNS AND THE OECD LEADING ECONOMIC INDICATOR
RETURN PREMIUM Year over YEAR
Despite these moderate cyclical tailwinds, secular headwinds persist. Global growth, inflation and interest rates are expected to remain low by historical standards, given the restraints of aging demographics, socioeconomic influences and the likely diminishing effectiveness of monetary policy.2
China, which accounts for over one-third of global GDP, is expected to enter a new phase of structurally slower growth as it matures into a higher income country.3 Additionally, China will continue to rebalance to a more consumption-driven model and readjust to a less foreign-dependent model, with the latter readjustment now likely to accelerate on the back of the recent U.S.-China disputes.
Such secular trends suggest that Asia ex-Japan companies will remain in a tough operating environment. Aggregate revenue growth and margins will likely come under further pressure in coming years as global trade activity contracts further and China growth slows. China’s transition from producer to consumer does not bode well for Asia ex-Japan companies, given that they are primarily exporters of manufactured goods.
Pricing power of Asia ex-Japan companies will also likely remain challenged. China’s industrial overcapacity will weigh on pricing power. China’s policy support for import substitution suggests that Asia ex-Japan exporters will be facing fiercer price competition from Chinese companies, especially in the technology hardware and semiconductors sectors. Additionally, technological advances and applications of artificial intelligence (AI) and machine learning (ML), big data analytics, blockchain, cloud computing, virtual/ augmented reality (VR/AR) and internet of things (IoT) will continue to disrupt traditional business models.
Higher ROEs for growth vs. value stocks support a continuing case for Asia ex-Japan growth
Given these persisting secular headwinds, we believe that the investment case for Asia ex-Japan growth stocks remains strong. Asia ex-Japan growth stocks have significantly outperformed value stocks since 2011, and are now trading very expensive to value stocks (Exhibit 7). Investors have been increasingly willing to pay a scarcity premium for growth stocks with longer-duration cash flows as growth and discount rates fall. Importantly, however, Asia ex-Japan growth stocks have also been posting significantly higher ROEs than value stocks, which provides some fundamental justification for their higher valuation (Exhibit 8).
Asia ex-Japan growth stocks have been strongly outperforming value stocks
EXHIBIT 7: MSCI ASIA EX-JAPAN GROWTH/VALUE INDEX RETURNS AND RELATIVE VALUATION
Asia ex-Japan growth/value outperformance is fundamentally backed by growth companies’ higher profitability
EXHIBIT 8: MSCI ASIA EX-JAPAN GROWTH VS. VALUE ROE
TRAILING 12 MONTH ROE
Accordingly, we continue to favor Asia ex-Japan growth stocks, particularly those with higher quality growth and profitability. We believe that Asia ex-Japan growth companies that can increase revenues, adapt and innovate their business models to fight today’s secular headwinds and capture structural growth potential will ultimately be able to generate profitability and deliver long-run outperformance.
Active stock selection remains key. Our investment focus will be on Asia ex-Japan companies that can find new revenue drivers (e.g. developing new products, expanding customer bases), raise competitiveness (e.g. growing quality franchises, increasing product differentiation) and/or improve margins and efficiency (e.g. cost cutting, capex discipline).
Riding cyclical tailwinds: We turn positive on Asia ex-Japan equities
For 2020, we expect cyclical headwinds to turn into moderate tailwinds for Asia ex-Japan equities as global growth moderately reaccelerates, U.S.-China trade tensions ease and earlier monetary policy support kicks in. With earnings revisions improving, the U.S. dollar moderating and MSCI Asia ex-Japan equities still attractively valued versus bonds, Asia ex-Japan equities could see further upside. We also expect Asia ex-Japan cyclicals to continue outperforming defensives.
Fighting secular headwinds: We remain positive on Asia ex-Japan growth stocks
Despite moderate cyclical tailwinds, we expect secular headwinds to persist in Asia ex-Japan equities. Global growth, inflation and interest rates are expected to remain low by historical standards. China is entering a new phase of structurally slower growth. Technological advances and applications will continue to disrupt traditional business models. Consequently, we expect Asia ex-Japan companies to remain in a tough operating environment. We continue to favor Asia ex-Japan companies that have higher quality growth potential and profitability as we believe they will ultimately deliver outperformance in the longer run.