We have rarely seen such a bearish mood in Hong Kong and China. Asia Pacific is nearing 5-year lows in terms of price earnings. In particular, China is close to its lowest multiples in 5 years; but its economic prospects (despite the comments of Larry Kudlow) are still good. We expect China’s GDP to grow 6% in the next year – and this means an additional US$840 billion of output on a US$14 trillion economy.
5 Year MSCI Asia Pacific Price/Earnings Ratio
5 Year Shanghai Composite EPS and P/E
The emerging markets are also at a very depressed and oversold level and have fallen 20% in 2018. Within the emerging markets, Asia now represents 75% with EMEA at 15% and LATAM at 10%.
Emerging Markets in 1988 vs 2017
When we consider that the Turkish lira and the Argentine peso have collapsed by -38% and -52% year-to-date, together with their respective stock markets, we can appreciate the contagion effect that this has on otherwise healthy economies in Asia.
Asian Currencies vs LATAM Currencies 1 Year Performance
Russia, too, has been suffering from US sanctions, and the Russian ruble and the Russian market have both reached new lows with negative effects on other Eastern European economies. Brazil has been dragged down by political uncertainty and the effects of the Venezuelan economic implosion have affected Colombia and its other immediate neighbors.
Asia stands out for political stability, financial strength, strong savings rates, and good growth prospects. India is growing at 8.2% on its last quarterly GDP numbers. The inflation rate is low at 3.7%, and real interest rates are high. The current account deficit, that India is currently experiencing, is half what it was 5 years ago, when it was 5%; and today, it is 2.4%, even with oil rising to US$80, and we expect US$100 by year end.
Mr. Modi is likely to get re-elected in May, 2019; the Reform Program will be maintained; corporate earnings are growing at 20%; and the Reserve Bank of India is probably one of the most conservative banks in the emerging world. The Foreign Portfolio Investors (FPI) owned by non-resident India have now been given some relief from the SEBI rule regarding KYC of beneficial owner of the fund. There has also been a concerted attack on corruption and bankruptcies in the corporate sector as well as the banking industry in India, which recently affected banking and financial stocks. September has been a torrid month for our Indian Ocean Fund, which fell 9%, together with the weakness of the Rupee. The Indian Rupee at 73 is now down by 14%, against the US dollar since the beginning of 2018. In our view, none of these extreme market corrections are justified by the economic fundamentals.
The real political risk today, it could be argued, is in Washington where President Trump, having threatened trade wars successively with Europe, Mexico, Canada, South Korea, among others, has settled new “deals” with all of them. This argues that he will logically find a new “deal” with China in due course, which would have a dramatic effect on the depressed share markets of Shanghai, Shenzhen, Hong Kong, and the region. The midterm elections on November 6 actually highlight the political risk facing the USA, since the possibility of the Democrats gaining the majority in the House, if not the Senate, will create paralysis and stagnation in the legislature, and possible impeachment proceedings against the president. This will surely lead to a fall in the US dollar and probably in the S&P 500.
The key for us is the relative performance of the US market and the US dollar compared with the rest of the world, in particular, with the emerging market index.
10 Year Ratio of S&P 500 / MSCI Emerging Market Index
In the past 30 years, we have never seen such an extreme outperformance of the US compared to the rest of the world. The key will be a change in the Dollar’s trajectory. As the US debt surpasses US$21 trillion, and interest rates rise towards 3% (and, as J.P. Morgan suggested, to 5% over the next 2 years), net interest payments annually will reach US$1 trillion, exceeding total defense or social security spending. At this point, it is hard to imagine there will not be some sort of crunch, or crisis, in the value of the US dollar, and the way foreigners perceive the risk in the Treasury bond market.
It is interesting to compare China, with US$3 trillion official reserves and US$7 trillion or more of private savings, and other Asian countries – Hong Kong, Japan, Korea, Taiwan, India – because there is clearly an imbalance in the world. The global savings glut, which has held down interest rates for the past several years, may now be reaching a moment of truth. Instead of 50% of Chinese savings being channeled into US funds, we may see soon a reversal by which the huge private savings in China and India are channeled instead into their own capital markets.
China’s contribution to global growth has risen from 12% in 2000 to 30% in 2017. China is also becoming creditor nation with external assets of US$6.2 trillion and is increasing its direct investment into Southeast Asia, both because of cost pressures and trade tariffs.
China is not only an investor but the leading trading partner of nearly all Southeast Asian countries, notably Indonesia, Philippines, Vietnam, the most populous ASEAN nations. In our model portfolio, we are now targeting 40% China, 30% India, and 30% ASEAN. Within Southeast Asia, we are overweighting Vietnam and Indonesia because of their large, young consumer populations. For instance, we have selected the Home Depot of Indonesia, Ace Hardware, as one of our core positions.
The health of the world economy depends on the Emerging Markets, which account for 59% of global gross domestic product – up from 37% in 1980. This enormous shift of the world’s economic balance in the past 30 years is principally due to China’s rise as a manufacturing and economic power, especially in the last 20 years. Now, many observers think that India is the next China, with its young population of nearly 1.5 billion, exceeding China’s, its growth rate surpassing China’s, and its open and democratic system of government proving, in the long-term, more resilient. No investor in North America or Europe can afford to ignore the potential of China and India as investment destinations in the next decade. Even if the oil price reaches US$100 a barrel, we expect that, as in 2007, the Asian markets can rise against this background of rising commodity prices. Inflation may be coming back as wages rise and labour shortages grow. But for the next 12 months, we see a coming shift of capital away from the overvalued US market into the value opportunity of Asia.
Robert Lloyd George
5 October 2018