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A stabilizing Chinese economy; a greater focus on corporate governance in Japan – and also in Korea and China; and less volatile currency markets, with no further depreciation of Asian currencies. These will be the three key themes in 2016, according to Arnout van Rijn, fund manager of Robeco Asia-Pacific Equities.
The only country in the region where Van Rijn still expects some currency depreciation is Australia. “The currency there is still not undervalued, which is what you’d expect, given the circumstances.” And the Chinese yuan then, which suddenly declined 3%? Van Rijn thinks further slight depreciation is possible. “What we saw in 2015 was a sort of test. To qualify for the IMF's SDRs, a currency must have a flexible exchange rate. However, China was shocked by the reactions to the sudden depreciation. They clearly want to move away from the dollar peg to a model like that used for the Singapore dollar, which is why a decision has been made to add the yuan to a trade-weighted currency basket.”
Van Rijn describes how until recently, Hong Kong residents would convert their assets as fast as possible into renminbi as it was a rock solid currency. “But now you're more likely to see the opposite. There is currently less pressure on the yuan, and people will accept limited depreciation, but China's walking a thin line. More significant depreciation could lead to panic in the market and to an outflow of capital.” However, that's not the base scenario. “I see little downside risk for this region. But not much upside potential either. The latter applies to the US and Europe too.”
Room for nuance
Van Rijn is strikingly nuanced in his outlook for China – a country which often triggers extreme analyses from both economists and investors, even if some of these are based on ignorance. He labels the industrial side of the economy as ‘weak’ and sees little recovery on the horizon, except for the tailwind provided by a number of infrastructure projects. However, the services side of the economy is healthy, unemployment is low, wages are growing at 8% and inflation is a respectable 1.6%. In the meantime, tourism continues its boom. The pros and cons are nicely balanced.
“An undefinable fear of debt-related troubles permeates government and businesses alike, as well as a distrust of shadow banking. And, yes, there is evidence of overcapacity in the industrial economy (steel, cement, electricity supply). Demand is disappointing and supply is not declining. The question is whether China is prepared to carry out restructuring to cut back in these sectors.”
There are signs that they may be prepared to do this. Van Rijn has observed that reforms are being implemented that will lead to greater liberalization and that, in contrast to the past, businesses are also being allowed to go bankrupt, albeit on a small scale. What's more, companies are gaining easier access to bond markets, making them less dependent on banks and facilitating debt refinancing.
Don't get too fixated on growth numbers
Meanwhile expected growth in China is slightly lower, at about 6%. Is the gradual decline in growth a risk? According to Van Rijn, investors shouldn't become too fixated on these numbers. For him it's ultimately all about how companies perform and whether they can maintain their profit margins. Although there's less of a tailwind economically speaking, corporate margins and earnings growth remain stable. “Despite the weak economy, earnings are not declining. Once growth stabilizes, I expect 8-10% earnings growth again, and in that scenario valuations are very low. And as long as earnings growth is 3%, valuations will not rise. The story would of course be different if earnings growth was -20%.”
So I don't expect a further equity market correction for this reason. All the more because the industries that are suffering strong headwinds have a much lower weight in equity indices than in the past. Steel represents just 3% of the index weight these days, while internet stocks make up more than 20%. And it's in e-commerce and fintech in particular that Chinese companies are leading the pack, both regionally and globally. More than 30% of garment sales now take place via internet.
Van Rijn’s fund is overweight in China. “Monetary policy is relaxed, reforms are being implemented and the banks have room to lend. Margin buying (equity investments with borrowed money by private investors) is back to a normal level after the sharp price declines in the summer of 2015.” But according to Van Rijn, it all boils down to finding the right stocks. “We took some profits in A-shares (Chinese equities with a local listing). In Hong Kong, we have stocks in the retail, real-estate and industrials sectors.” Chinese blue chips are reasonably valued, according to Van Rijn. In the smallcap and microcap segment, specifically in technology and internet stocks, there are many stocks with high valuations.
No new currency crisis
Van Rijn is not concerned about a rate hike having the same effect on Asia and Asian currencies as it did in the late nineties. “In China, we saw a strong correction in the third quarter, causing a thorough shake out which got rid of the weaker players. And I don't expect the Fed’s higher rates to have any unfavorable effects on Korea and Taiwan. Only perhaps on India.” In fact, as a value investor, Van Rijn actually sees advantages in higher interest rates. “Growth stocks do well when rates are low. They are long duration assets (cash flows are way down the line) and are therefore more sensitive to rate hikes than short duration value stocks. In a higher interest-rate environment, value stocks perform better in relative terms than growth stocks.”
Van Rijn doesn't think Japan will be hit hard by a rate hike in the US. Banks and insurers will benefit from it. Monetary policy is geared to allowing inflation and interest rates to rise. Whatever happens in the US will not have much of an impact. Van Rijn primarily sees opportunities in countries in which local investors play a significant role: Japan, China and India. He also does not expect a new currency crisis, triggered by rising US rates, leading to a stronger dollar and higher dollar-denominated debt in Asian emerging markets.
“The currencies of Malaysia, Thailand and now also Indonesia are all dirt cheap. They are as much as 40% undervalued.” In short, there is not much downside potential left there. The currency effect had a major impact on markets in 2015, driven by the exodus of capital. “If those money flows return, we will see a recovery. But if we only see a stabilization of the situation, the recovery will be brief at best and thereafter the index is likely to trade in a narrow range.”