What's the outlook for Asian equities?

James Thom on the structural trends that remain in Asia’s favour and why the second half of the year will be a time for active management.

The outlook for Asian equity markets appears unsettled amid the fallout of the coronavirus pandemic and risk of recessions, even as nations ease lockdowns and re-open their economies.

Strict measures to curb virus transmission have weighed heavily on economic and business activity. The longer the pandemic persists, the more this disruption will stymie recovery in the second half of 2020.

A second wave of infections in countries where curbs were lifted too early remains a key risk. Moreover, the flare-up of US-China tensions and the run-up to the US presidential election in November presage further volatility.

While sustained stimuli from governments and central banks will offer continued support to markets, investors should remain cautious.

Progression of the pandemic has varied considerably across the Asia-Pacific region. We see risks to the economy, and even social stability in countries such as India and Indonesia. At the same time, many Asian governments have proved adept at managing this crisis. They took difficult decisions at an earlier juncture and are now better placed to restart their economies.

China, South Korea, Taiwan, Hong Kong, Australia and New Zealand look set to suffer less economic damage owing to effective implementation of countermeasures. Together, these markets represent more than 80% of the benchmark MSCI AC Asia Pacific Ex-Japan Index.

Asia benefits from economic orthodoxy, leaving central banks in the region more room to cut rates than Western peers that have run out of conventional monetary policy firepower.

Most Asian countries also have stronger current accounts, government debt to GDP and individual, bank and company balance sheets. This should offer reassurance to investors as they look ahead.

In addition, structural trends remain in Asia’s favour, notably the consumption power of an increasingly wealthy middle class. The region is home to half the people on the planet and accounts for almost half of global GDP. It’s also at the forefront of technology shifts, including the adoption of 5G, autonomous driving, artificial intelligence and automation.

Discerning winners and losers

We urge investors to focus on two factors in the second half: which firms are positioned to weather the Covid-19 storm; and what normalised company earnings will look like.

First, investors should differentiate on quality, by which we mean companies with strong balance sheets, low levels of debt and sustainable competitive advantages operating in sectors with structural growth prospects. They tend to be more resilient during downturns.

As financial distress exposes weaker firms, investors will need to assess opportunities stock by stock. It underlines why the second half of this year will be a time for active management. Passive funds can’t avoid weaker companies because they hold everything, good and bad.

Investors will need to study companies’ balance sheets, debt maturities, cash flows and the long-term sustainability of their strategy. Considering risks and opportunities around environment, social and governance (ESG) factors will also remain important.

We have found that managements able to discuss key risks and how to mitigate them are the ones that have avoided blow-ups and created shareholder value. Owning quality remains the best way to mitigate risk.

Second, we expect company earnings to remain under pressure. Many firms have scrapped or deferred dividend payments and cut back on capital expenditure. Cost and operational efficiencies may become differentiating factors to focus on.

Investors might take industry outlooks into account. Consumer discretionary stocks such as autos, retailers, travel and tourism have been hit hard. However, amid a gradual loosening of lockdown measures, we are seeing nascent signs of a recovery in demand in some markets.

Domestic flights have resumed in China, while certain retailers should continue to prosper as consumers stock up on electronics to facilitate working from home. E-commerce sales are also likely to remain resilient.

We continue to like the tech sector, which remains underpinned by structural growth drivers such as cloud computing, data centres, 5G and digital interconnectivity. However, we are mindful that tech is becoming a politically sensitive issue in the run-up to the US election amid disruptive pressure on Huawei and increasing friction between the US and China.

We retain a negative outlook on banks as interest-rate cuts eat into margins and amid pressure to support customers and the economy through loan holidays and deferred interest payments.

But while we see risks on the horizon, the market appears largely to have priced these in. Despite the recent market rebound, Asian equity valuations remain undemanding. On a trailing price-to-book basis as of June 5, the MSCI AC Asia Pacific ex-Japan Index was trading at a 15% discount to its 10-year average and over a 60% discount to the S&P500.

As valuations diverge across segments, investors might look beyond the short-term noise to identify long-term opportunities. We see the brightest prospects for quality Asian stocks with strong fundamentals in line to benefit from the region’s structural growth.

Areas of interest include premium consumption in segments such as healthcare, wealth management and insurance; adoption of tech services such as the cloud and roll-out of 5G; and the region’s growing urbanisation and infrastructure needs.

James Thom is investment director at Aberdeen New Dawn Investment Trust.