In brief

• Asia ex-Japan (AXJ) equities lagged significantly last year, underperforming  both developed market (DM) and emerging markets (EM) equities, ending the year in negative territory at -4.7%.
• In this first part of a two-part paper, we explore the common push-backs to investing in AXJ and broader EM equities as we enter a monetary tightening regime in the U.S.
• We address why we think things are different this time for AXJ countries, as starting macroeconomic conditions are more favorable than before.
• Specifically, we see (a) potential for 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 paper of this two-part series will be a deeper dive into the year-to-date (YTD) performance, valuations, reasonableness of the earnings outlook for AXJ equities and conclude with investment implications.

Introduction

Asia ex-Japan (AXJ) equities lagged significantly last year, underperforming DM equities by 26.5% and the generic EM equity index by 2.25%, ending the year in negative territory at -4.7% (Exhibit 1). While there were individual country winners like India and Taiwan, they were not enough to offset the weakness that resulted from regulatory headwinds and the shift toward a more sustainable growth model in China. In ASEAN, intolerant COVID-19 policies significantly curtailed mobility, impacting consumption and slowing down the pace of economic recovery.

With other historically significant EM headwinds surfacing as we enter the new year—think higher U.S. real rates, less accommodative monetary policies, a stronger dollar—we thought it would be useful to revisit the case for AXJ vs. DM equities in the context of these headwinds and investigate why we think things can be different this time.

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.

EXHIBIT 2: POSITIVE GROWTH CONDITIONS PROVIDE A HEALTHY EARNINGS BACKDROP FOR AXJ AND EM EQUITIES
AVERAGE MONTHLY RETURNS UNDER SIMILAR GROWTH REGIMES
Source:  Bloomberg, FactSet, J.P. Morgan Markit Global PMI, J.P. Morgan Asset Management.
Data starts in December 1999 and reflects most recently available as of 14/02/22. ^Environment: Expansionary; Pace of Growth: Moderating is defined as above 3-month average levels of J.P. Morgan Global New Orders PMI, with negative momentum in the 3-month moving average of the series. *Cashflow return = Dividends + Share count change.

Where are we in the global cycle?

While history doesn’t exactly repeat itself, it often rhymes. Evaluating periods in the past that resemble conditions that we have today, i.e. still strong but moderating pace of growth, has shown that these have often been challenging periods for the valuation component of returns. However, as growth remains robust, the earnings component should still be strong enough to more than compensate for the losses from contracting multiples. Exhibit 2 shows that these conditions have typically been encouraging for equity-bond relative returns and underscores our preference for the former vs. the latter in the asset allocation hierarchy. AXJ and EM equities have historically generated stronger excess returns vs. the U.S. 10-year Treasury bond compared to their DM equity counterparts.

A deeper dive into growth differentials

A common concern that is often raised is that the GDP growth differential between AXJ and developed markets has continued to fall and that dynamic could pose as a headwind to the outperformance of AXJ vs. DM equities.

Firstly, it is important to know that economic composition may not necessarily be the same as equity index composition. Hence, it should follow that the topline growth of an equity region would depend on where that growth is coming from. In an increasingly globalized world, it is plausible that companies listed on the AXJ exchange source their revenues from all over the globe. Rather than focusing on GDP growth differentials, we can more directly map out the forward-looking growth trajectory of an equity region by breaking down its revenue sources by country and looking specifically at the growth path of those countries, i.e. create a blended Purchasing Managers’ Index (PMI) series for each region weighted by their respective geographical revenue contributions. Taking it one step further, we can also break down how much of an equity index is linked to manufacturing vs. services. We believe that this is a more precise measure of the expected growth path of an equity index.

EXHIBIT 3: ASIA EX-JAPAN EQUITIES TYPICALLY OUTPERFORM DM WHEN GROWTH DIFFERENTIALS ARE NARROWING SEQUENTIALLY
SECTOR AND GEOGRAPHICAL REVENUE BLENDED RELATIVE PMI DIFFERENTIALS
Source: Bloomberg, Haver, J.P. Morgan Asset Management.
Data reflect most recently available as of 31/01/22.

Earlier in the pandemic (2020), the relative growth differentials between AXJ and DM equities using this blended index were skewed in favor of AXJ. This is because AXJ countries reacted swiftly with a heavy-handed approach. Borders and activity within were shut down very quickly to contain the virus and not overwhelm their health care systems. However, as developed markets learned to co-exist with the virus, AXJ continued to adopt a strict approach with closed borders and mandatory quarantines. When the Delta variant hit in mid 2021, growth differentials started to diverge in favor of developed markets as a result of this approach. However, as AXJ economies started to understand the virus and became more well equipped to deal with each subsequent wave, the growth differentials have started to narrow. We believe that AXJ economies will continue to reopen as they learn to co-exist with the virus, and with China pivoting to a more accommodative monetary and fiscal policy stance, forward-looking growth expectations in the region look brighter than before.

Historically, when our measure of  growth differentials between AXJ and DM equities are more positive than average and the 3-month trend of the narrowing of the differentials is positive, this has seen AXJ equities outperform DM equities by an average of +1.3% over the next 12 months. If we just look at the 3-month trend in isolation, when it has been on a positive trajectory historically, AXJ has typically outperformed DM equities by an average of +0.4% over the next 6 months.

Can AXJ equities weather higher U.S. real rates?

It is true that relative to developed markets, AXJ equities demonstrate a higher negative sensitivity to rising U.S. real rates, as evidenced by negative and statistically significant betas across the various geographical components (Exhibit 4). However, it is also important to note that the relative sensitivities vary across the different components of AXJ, with Australia, Hong Kong, Malaysia and Singapore demonstrating the least relative sensitivity to rising U.S. real rates vs. DM equities, while Indonesia and Philippines are about 4-5x more sensitive. Within sectors, the most sensitive sector is Real Estate, while Industrials and Financials have about half the sensitivity to rising U.S. real rates.

Australian, Hong Kong, Malaysia and Singapore equity indices are heavily dominated by Financials, with about 33 to 50% of their respective market capitalizations in the sector. This helps to explain why the overall sensitivity of these markets to higher U.S. real rates are lower because higher rates generally benefit net interest margins.

We think it is likely that AXJ countries can benefit from stronger U.S. growth and weather higher U.S. rates better than before because macro stability in the region has improved relative to the 2013 taper tantrum episode. The vast majority of AXJ constituent countries saw improvements in their current account balances today vs. 2013 (Exhibit 5), apart from Philippines and Malaysia. 

EXHIBIT 4: SENSITIVITY TOWARD U.S. REAL RATES VARIES AMONG ASIAN EQUITIES
10Y RELATIVE TO MSCI WORLD BETA TO U.S. REAL RATES
Source: Bloomberg, J.P. Morgan Asset Management. Betas are calculated using weekly data over the past 10 years and all betas are statistically significant at the 5% alpha level.
Data reflect most recently available as of 10/02/22.

Indonesia ran a current account deficit of -3.5% on average in 2013. Its dependence on external funding heading into a period where U.S. real rates reset abruptly higher was what led to a prolonged episode of currency depreciation. 

EXHIBIT 5: CURRENT ACCOUNT BALANCES HAVE IMPROVED SINCE 2013
CURRENT ACCOUNT AS A % OF GDP
Source: Bloomberg, J.P. Morgan Asset Management. Betas are calculated using weekly data over the past 10 years and all betas are statistically significant at the 5% alpha level.
Data reflect most recently available as of 10/02/22.

Moreover, with markets now pricing in close to seven rate hikes in 2022, we think the bulk of the pain in terms of rising real rates is behind us. On the bright side, longer-term inflation expectations (5y5y forward) have remained remarkably well anchored at around 2.5% even as shorter-term inflation prints have spiked. 

EXHIBIT 6: ASIA EX-JAPAN VS. U.S. REAL RATE DIFFERENTIALS ARE MUCH WIDER TODAY COMPARED TO 2013
MSCI ASIA EX-JAPAN VS. U.S. REAL RATE DIFFERENTIAL OVER TIME
Source: Bloomberg, J.P. Morgan Asset Management.
Data reflect most recently available as of 15/02/22.

Let’s address FX too

The concern about the impact of rising U.S. real rates on AXJ FX returns is a valid one. AXJ FX accounts for close to 20% of AXJ equities’ volatility, while DM FX’s share of DM equity volatility is closer to ~10%. Hence, FX is an important consideration when investing in AXJ equities.

Real rate differentials between AXJ and the U.S. have made a comeback in more recent time periods in explaining relative FX returns (with R squares rising from 0% over a 5Y time period to ~20% over the past 6 months). Unlike the taper tantrum time period back in 2013, real rate differentials between AXJ and the U.S. are much higher today, which should lend some support to Asian currencies. Higher real rate differentials today also help to add to the macro stability narrative vs. 2013.

Moreover, AXJ currencies are screening as slightly undervalued relative to history across a variety of FX models (Exhibit 7). We take a closer look at Purchasing Power Parity (PPP) models that take into consideration inflation and productivity differentials. Behavioral Equilibrium Exchange Rate (BEER) models are a more sophisticated version of PPP models that takes into account other important variables, like terms of trade differences, ratio between domestic and foreign productivity levels and degree of openness. Lastly, we do not forget the Fundamental Equilibrium Exchange Rate (FEER) models, where currency valuations depend solely on the current account balance of a country and how that projects onto Real Effective Exchange Rate (REER) misalignments. The relative cheapness of the FEER metric today is a reinforcement of our earlier observation on how the current account balance situation is much healthier today than in 2013 for AXJ constituent countries. 

EXHIBIT 7: CHEAP ASIA EX-JAPAN CURRENCY VALUATIONS SHOWCASE THE PROTECTION OFFERED BY HEALTHIER CURRENT ACCOUNT BALANCES
MSCI ASIA EX-JAPAN FX MIS-ALIGNMENT VS. USD ACROSS VARIOUS FX MODELS
Source: Bloomberg, Deutsche Bank, J.P. Morgan Asset Management. *FEER stands for Fundamental Equilibrium Exchange Rate. **BEER stands for Behavioral Equilibrium Exchange Rate. ***PPP stands for Purchasing Power Parity.
Data reflect most recently available as of 31/01/22.

Conclusion and Part II preview

In addressing the common push backs to investing in AXJ and broader EM equities, historical analysis gives reason to suggest AXJ and EM equities could perform positively over the near term. Economic re-opening in the region has seen the narrowing of growth differentials relative to developed markets, which typically bodes well for AXJ and EM equities, while improved macro fundamentals relative to 2013 give us confidence that AXJ and EM equities and currencies are in a much better position to weather the anticipated rise in U.S. real rates.

With the macro backdrop established, in part II of this note we establish the key tenets forming our positive outlook on AXJ equities from a valuation and earnings outlook perspective. We showcase how AXJ equity valuations remain compelling across several key metrics and highlight the key economic drivers of corporate earnings in the region.

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