In brief

• In the first part of this series, we addressed the common push backs to investing in Asia ex-Japan (AXJ) and broader Emerging Market (EM) equities as we enter a monetary tightening regime in the U.S.
• On a year-to-date (YTD) basis, AXJ equities have indeed demonstrated resilience in the face of volatility and have outperformed Developed Market (DM) equities.
• We take a closer look at valuations and evaluate the reasonableness of the earnings outlook for AXJ equities.
• AXJ equities remain attractively valued, even after adjusting for sectoral compositional changes over time vs. DM equities.
• Export growth is expected to moderate but remain at high levels. We believe that should continue to lend support to AXJ earnings.
• After a difficult year of regulatory-induced headwinds, China (the biggest component of AXJ equities at 35% of market cap) is poised to deliver close to mid double digit EPS growth in 2022 as the policy stance shifts to becoming more accommodative.

How have Asia ex-Japan (AXJ) equities fared year to date? 

Exhibit 1: Asia and emerging market equities underperformed in 2021
Equity returns in 2021 - Growth of 100
Source: Bloomberg, J.P. Morgan Asset Management.
Data reflect most recently available as of 31/12/21.

While Asia ex-Japan (AXJ) equities underperformed relative to DM in 2021, they have indeed demonstrated resilience since the turn of the year. Through February 15, 2022, the index was down ~1.6% vs. DM equities, which are down closer to ~5.4% in USD terms.

Even after the relatively encouraging performance vs. DM equities so far, AXJ equities still look relatively cheap vs. DM equities across a variety of valuation indicators. Some might argue that this may be a bit of an unfair comparison because the composition of the AXJ equity index looks quite different from the DM equity index. For example, the AXJ index is more heavily weighted towards Financials, which is a value sector and has been penalized for the last decade due to lackluster net interest margins and loan growth. However, even after sector-adjusting across various valuation metrics (Exhibit 2), AXJ equities still look more attractive than their DM counterparts.

Exhibit 2: Asian equity valuations look compelling across various metrics
Relative valuations of MSCI Asia ex-Japan vs. MSCI World - Sector adjusted

Price-to-equity (P/E), next 12 months

Free cash flow yield (FCFY), next 12 months

EV / EBITDA, next 12 months

Price-to-book (P/B), next 12 months
Source: FactSet, J.P. Morgan Asset Management.
Data reflect most recently available as of 15/02/22.

Earnings revisions are still positive

Another common concern is earnings revisions. Indeed, 3-month earnings revisions have been on a downward trend ever since the Delta variant slowed down activity in the region sharply mid last year. However, the good news is (a) earnings revisions are still positive and (b) the latest dip in earnings revisions as a result of Omicron disruptions was barely a blip in the time series, indicating that each successive wave has lesser and lesser impact on regional economics. As we get past the headwinds that Omicron will post to mobility and consumption in the first quarter of 2022, we see the potential for earnings per share (EPS) revisions momentum to recover.

Exhibit 3: MSCI Asia ex-Japan EPS revision is positive and beta towards COVID-19 outbreaks has declined
Next twelve months EPS revisions 3 months momentum
Source: Bloomberg, J.P. Morgan Asset Management.
Data reflect most recently available as of 15/02/22

Earnings expectations are reasonable

Market consensus expects AXJ EPS to grow at a pace of 9.3% for 2022. This compares favorably with DM equities, which are expected to deliver 7.3% over the same time period. How do we know if a 9.3% growth rate is reasonable?

Looking at the relationship between a forward-looking indicator of demand (New Orders Purchasing Managers’ Index (PMI) Sub-Index) and trailing 12 months (TTM) earnings growth, one can see that these two move together to a great degree, with the strongest relationship at the 6-month lead point, i.e., New Orders lead TTM earnings growth by 6 months (Exhibit 4). 

Exhibit 4: Asia ex-Japan earnings correlates positively with export demand
Relationship between New Orders and trailing 12 month earnings growth
Source: FactSet, Haver, J.P. Morgan Asset Management.
Data reflect most recently available as of 01/31/22.

Due to Delta’s disruption in the mid-2021, New Orders fell off a cliff, but the series has gradually started to recover since. Going forward, we can expect any temporary weakness in earnings growth to quickly bounce back along with the trend that we saw play out in New Orders. Historically, when New Orders remained at or above average levels (51.8), the average earnings growth experience was closer to 13.2% per annum. This tells us that analysts’ estimates on AXJ earnings are not overly exuberant, considering the stage of the cycle and the forward-looking demand picture.

The focus on the New Orders sub-index as a leading indicator is pertinent because of the linkage between export growth and earnings growth in the region. New Orders typically lead export growth in the region by ~4 months. When New Orders are above average levels, we typically also see strength in year-over-year (y/y) export growth of around 18%. While this suggests a moderation of the export growth from current levels (>20%), we believe that a high teens export growth number should continue to support the earnings trajectory for AXJ equities. 

Exhibit 5: 2022 earnings to be led by China and ASEAN
MSCI Asia ex-Japan earnings expectations for 2022/2023 - By regions

MSCI Asia ex-Japan earnings expectations for 2022/2023 - By sectors
Source: Bloomberg, Haver, J.P. Morgan Asset Management.
Data reflect most recently available as of 31/01/22.

Earnings growth to be led by China and the majority of ASEAN

After a difficult year of weathering regulatory-induced headwinds, Chinese equities (the biggest component of AXJ equities at 35% of market cap) are poised to deliver close to mid double digit EPS growth in 2022 as the policy stance shifts to becoming more accommodative. As Taiwan and Korea had a strong 2021, earnings expectations are more muted going into 2022 (Exhibit 5).

Hence, the recovery in AXJ earnings is expected to be led by China and the majority of ASEAN, especially as the latter economies work through the impact of Omicron.

While not the biggest contributor to market capitalization within AXJ equities, AXJ Financials make up the biggest weight in earnings at 30%, followed by AXJ Information Technology at ~23%. These two sectors make up more than half of total earnings at the index level.

Both sectors are poised to deliver strong earnings growth in 2022 at ~9% and ~16%, respectively. While consensus expects a strong rebound in AXJ Consumer Discretionary in 2022, with ~35% earnings growth as AXJ economies reopen and gradually return to normalcy, it is a much smaller part of total index earnings at a 6.7% weight. The AXJ region has not really seen the cyclical recovery that the developed world has experienced over the past year, and given that ~40% of the earnings of the index is Financials and Industrials, these cyclical sectors should be in a strong position to do well as the region returns to growth. 

Conclusion and investment implications

In conclusion, it might be tempting to continue to assume that AXJ equities will continue to underperform as they traditionally have heading into a monetary tightening regime in the U.S.

In the first part of this two-part paper, we explored the common push backs to investing in AXJ equities and addressed why we think things can be different this time as starting macro conditions for many AXJ constituent countries are more favorable than before.

Specifically, we see (a) potential for our computed measure of growth differentials between AXJ and DM equities to continue to narrow, (b) improved current account balances, (c) higher real rate differentials and (d) cheaper starting valuations of AXJ currencies since 2013.

The second part seeks to address two of the key drivers of equity returns – valuations and earnings.

It is our view that valuations look compelling against DM equities even after adjusting for the differences in sectoral composition across time. Earnings revisions have come down significantly but continue to remain in positive territory. It is also our view that consensus expectations of AXJ equities’ earnings growth for 2022 is not overly exuberant, and that a ~9% growth rate is very reasonable and achievable. With more attractive valuations and better earnings growth potential vs. DM equities, we believe AXJ equities are better set up to outperform DM equities.

As most economies have now moved past the phase of rapid economic recovery coming out of a deep recession, 2022 is not the year to just be “in the markets.” Country and sector selection are going to be going forward.

• Be selective at the country level: Chinese equities are attractive from a diversification perspective because we expect China to transition to an easier monetary and fiscal regime vs. many parts of the developed world.
• After a difficult year of weathering regulatory-induced headwinds, Chinese equities (the biggest component of AXJ equities at 35% of market cap) is poised to deliver close to mid double digit EPS growth in 2022 as the policy stance shifts to becoming more accommodative. As Taiwan and Korea had a strong 2021, earnings expectations are more muted going into 2022.
• AXJ Financials and Technology sectors make up more than half of total earnings at the index level. Both sectors are poised to deliver strong earnings growth in 2022 at ~9% and ~16%, respectively.
• Due to stricter virus control measures, the AXJ region has not really seen the cyclical recovery that the developed world has experienced over the past year, and given that ~40% of the earnings of the index is Financials and Industrials, these cyclical sectors should be in a strong position to do well as the region returns to growth.

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