Who will ride out the DM turbulence best?
- Recession warnings from the U.S. and Europe threaten to derail Asian economies’ nascent recovery, mainly through a drag on export demand.
- Levels of export exposure to the U.S. vary greatly among Asian economies, but they have generally come down in the past two decades, while export dependence on China has increased. Asian trade growth is coming from within the region rather than outside it.
- Countries such as Vietnam, which has higher export exposure to the U.S. and is more sensitive to the U.S. consumer, is likely to be harmed more by a U.S. slowdown. Meanwhile, Indonesia, with its higher dependence on domestic consumption, looks more insulated against external shocks.
With recession risks heightening in the U.S. and Europe, some investors have turned to Asia, eagerly hoping to find outperforming stocks, especially since Asian equities have performed relatively well in H1 2022 in the face of global shocks. Indeed, the Russia-Ukraine crisis had relatively less direct impact on most Asian economies, given limited trade relationships with Russia (only around 1.5% of Asian exports go to Russia) as well as low reliance on natural gas and wheat. Asia also initially saw fewer signs of overheating, so central banks could afford more gradual rate hikes. However, as various headwinds erode global demand, APAC is not insulated. Specifically, emerging Asia’s quarter-over-quarter (q/q) GDP contracted for the first time since 4Q20 (Exhibit 1).
Although Asia is regarded as one region, it’s worth reminding ourselves that there are plenty of idiosyncrasies within, which bring forth less synchronized recovery paths. For example, just within emerging Asia, Laos hit a 22-year high inflation print of 23.6%, while Malaysia’s inflation in June was only 3.4%.
While a global recession is not in our base case, we think there will be a significant slowdown at the very least. Risks are currently higher in developed markets, with Europe more vulnerable than the U.S. given the energy crisis. Thus, we will try to examine Asian economies’ external and domestic demand exposures to understand who are better positioned to ride out any contagion from the West.
Where do Asian exports go?
Exports are a key driver of Asian economies and they move fairly in tandem with APAC earnings (Exhibit 2). With most Asian exports being goods, there are high contagion risks from weaker external goods demand. In April, the World Trade Organization revised down the 2022 global trade growth forecasts from 4.7% to 3.0%, with 2023 growth inching up to only 3.4%. As Asian countries are just emerging from COVID-19 lockdowns, slowing trade seems to be a threat to turn the region’s recent economic growth on its head.
EXHIBIT 2: EARNINGS PER SHARE IN ASIA CLOSELY TRACK NOMINAL EXPORT GROWTH
USD, YEAR-OVER-YEAR CHANGE
But the picture is much more nuanced than that. Taking exports to the U.S. as an example (Exhibit 3), there are significant discrepancies among Asian countries. Apart from Vietnam, other economies only export 10% or less of GDP to the U.S. Compared with the past two recessions, export exposure has significantly come down, again, with Vietnam being an exception, partly due to supply chain reshuffling in the region, which saw some companies moving production from China to Vietnam. Having said that, we are still very far from decoupled, as the U.S. continues to be a key driver of economic activity and growth in Asia beyond exports.
EXHIBIT 3: ASIAN ECONOMIES’ EXPORT EXPOSURE TO THE U.S. HAS DECREASED OVER TIME
VALUE OF EXPORTS TO THE U.S. AS A PERCENTAGE OF NOMINAL GDP, USD
On the contrary, export exposure to China has increased significantly over time (Exhibit 4), with a caveat that part of these exports are for processing in China only and ultimately consumed by Western consumers. China retail sales rebounded after recent lockdowns, beating expectations by rising 3.1% year-over-year in June 2022, while red-hot inflation and rising borrowing costs are eroding consumer confidence in the U.S. and Europe. However, given the onshore risks in China regarding COVID-19 policy and the property market, it is still highly uncertain whether Asian economies can rely on China to boost their tourism and exports in the near term.
Beyond China, there has also been strengthened regional trade and value chain linkages among Asian economies. Intraregional trade now takes up around 25% of ASEAN’s total trade and countries like South Korea are seeing significantly higher export growth to ASEAN than to other regions, including to China. Stronger regionalization and economic integration will be key to a resilient recovery.
EXHIBIT 4: ASIAN ECONOMIES’ EXPORT EXPOSURE TO CHINA HAS INCREASED OVER TIME
VALUE OF EXPORTS TO CHINA AS A PERCENTAGE OF NOMINAL GDP, USD
Apart from the level of export exposure, we also looked at the sensitivity of Asian exports to U.S. economic activity. In fact, Asian exports are still fairly highly correlated with both U.S. investments and retail sales, with the former being more of a leading indicator while the latter is relatively concurrent. However, the sensitivity varies across economies, suggesting that the extent of contagion risks to each country also depends on the type of U.S. recession that unfolds. Exhibits 5 and 6 plot export exposure against the sensitivity to U.S. investments and retail sales. Economies closer to the upper-right quadrant of the scatter plot would be most at risk. Exhibit 5 shows that an investment-led recession in the U.S. would likely impact South Korea and Japan more, due to larger exports of capital goods such as machinery, vehicles, equipment etc., but we’re less concerned because export exposure as a percentage of GDP is still considerably low. Looking at Exhibit 6, consumer goods exporters Thailand, Malaysia and especially Vietnam have relatively high export exposures and correlations with U.S. retail sales. Current weakness observed in the U.S. economy is mainly concentrated on the consumption side rather than investments. Thus, these countries that export cheaper consumer products are more vulnerable.
EXHIBIT 5: CORRELATION WITH U.S. CORPORATE INVESTMENTS SINCE 2010
EXPORTS TO THE U.S. AS % OF GDP, CORRELATION BETWEEN QUARTERLY YEAR-OVER-YEAR CHANGES IN EXPORTS AND U.S. PRIVATE DOMESTIC NON-RESIDENTIAL INVESTMENTS (INVESTMENTS LEADING EXPORTS BY 2 QUARTERS)
EXHIBIT 6: CORRELATION WITH U.S. RETAIL SALES SINCE 2010
EXPORTS TO THE U.S. AS % OF GDP, CORRELATION BETWEEN QUARTERLY YEAR-OVER-YEAR CHANGES IN EXPORTS AND IN U.S. RETAIL SALES
For a sustained recovery, domestic demand would be an important buffer to counter the drag on exports. With the recent re-openings, we can expect Asian domestic demand to follow a similar recovery path to the U.S. and Europe, with an initial pick-up in goods demand, followed by a more sustained recovery in services such as F&B and transport. The rebound in tourism has been impressive so far, but with slowing growth in the U.S. and Europe, countries with larger existing domestic or regional tourism, rather than relying on inbound visitors, will likely stay more resilient. Although the initial rebound in domestic consumption data is affected by a low base, pent-up demand does take considerable time to be fully unleashed, as we’ve witnessed in the West.
Indonesia, the largest economy in Southeast Asia, both in population and economic size, has its MSCI constituents derive 91% of revenue domestically, with a total of 97% from Asia (Exhibit 7). Naturally, it is also one of the least export-oriented countries (Exhibit 3 and 4), relatively insulated from external contagion risks. Other ASEAN countries like the Philippines and Thailand also rely a lot on domestic demand and have more diverse sector weights in their indices. If the strength in domestic mobility, retail sales and consumer confidence persists, coupled with the accelerated vaccine rollouts and government stimulus that we’ve seen so far, domestically oriented Asian economies will likely be more supported. It is also worth remembering that while Asian export growth explains the ups and downs of earnings volatility in Asia (Exhibit 2), domestic structural growth is still a significant long-term driver and much more consistent over time.
EXHIBIT 7: INDONESIA HAS THE LARGEST DOMESTIC REVENUE EXPOSURE
GEOGRAPHIC REVENUE EXPOSURE OF MSCI INDICES
Conclusion and investment implication
With the downside risks to global growth, Asia’s recovery will slow, but we don’t think it will be derailed, especially with Asia’s decreasing export exposure to the West. Also, even with the borders of the largest economy in the region being closed for the past few quarters, Asia ex-China was able to bolster an impressive recovery so far by relying on intraregional trade and domestic consumption.
Looking at individual countries’ economic reliance externally and domestically, the speed and breadth of recovery will be far from consistent if there is a Western recession. Within the region, we think Vietnam will likely be hard hit due to its high and increasing export exposure to the U.S., followed by Thailand and Malaysia. In the case of an investment-led recession, countries like South Korea and Japan will be impacted more due to their high sensitivity to U.S. investments. On the flip side, we think larger economies with higher reliance on domestic activity will likely be more resilient, such as Indonesia, Philippines and India. Country diversification is still important, as we still see idiosyncratic risks that could derail recovery for individual countries, such as vaccine rollouts, government policies, inflation and so on.
Beyond country selection, active sector and stock selection are especially important considering Asian companies’ varying degrees of exposure to exports and domestic consumption. Other factors such as cyclicality, given the early economic stage, as well a pricing power, to protect margins in periods of inflation, are also important.