MARKET INSIGHTS Market Bulletin March 1, 2018 Asian equities: More room to run? In brief Solid global economic and trade growth are crucial tailwinds supporting Asian equities. Valuations are in line with long-run averages. Earnings improvements are broadening as benefits from better growth spread to more sectors of the economy. Headwinds, such as rising rates in the U.S. or rising protectionism globally, remain manageable. Asian equities deserve to be in any Asian and international investor s portfolio, whether for total return or income generation. Tai Hui Chief Market Strategist Asia GREAT PERFORMANCE LAST YEAR, BUT CAN ASIA DO BETTER? 2017 was a great year for Asian equities, and we believe earnings should remain supportive of future performance in the coming 12-18 months. The pick-up in the global trade cycle that began in 2016 was a crucial catalyst for an earnings recovery in Asia, which kick-started a virtuous cycle of capital expenditures. Despite 2017 s strong performance, equity valuations are in line with their long-term averages. Even taking into account the potential headwinds, including faster-than-expected policy normalization in the U.S., a stronger U.S. dollar, and the threat of a trade war between the U.S. and China, the outlook continues to be constructive. Asia equities complement a variety of strategies both in Asia and internationally, such as income generation or capital growth focused objectives for investors. Ian Hui Global Market Strategist
Corporate earnings: Rising from the ashes Asia and emerging markets (EM) went through a difficult period between 2011 and 2015, when a weaker global trade environment and a precipitous decline in commodity prices weighed on earnings. The recovery in global trade in late 2016 and 2017 coincided with a revival of Asian corporate earnings (Exhibit 1). It is an oversimplification though to attribute improved Asian corporate earnings to the region s export performance alone. There are a number of crucial structural trends in place, such as the rise of consumers in China, India and ASEAN, as well as the increased demand for infrastructure projects in the region. Nonetheless, the recovery in the trade cycle did provide a much needed cyclical boost to the region. Recovery in trade coincides with earnings improvement EXHIBIT 1: GROWTH IN NOMINAL EXPORTS AND EARNINGS PER SHARE USD, YEAR-OVER-YEAR CHANGE 80% 60% 40% 20% 0% -20% -40% MSCI AC Asia Pacific ex-jp EPS EM Asia ex-china exports* -60% '01 '03 '05 '07 '09 '11 '13 '15 '17 Source: CEIC, FactSet, MSCI, national statistics agencies, J.P. Morgan Asset Management. *EM Asia ex-china includes Hong Kong, Malaysia, Singapore, South Korea, Taiwan, Thailand and Vietnam. Overall exports aggregate is GDP-weighted. Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 31/12/17. If 2017 was a year where earnings rose from the ashes, 2018 and 2019 are likely to be years where headline earnings growth slows down, but is more evenly distributed across sectors. 2017 saw the rebound of energy and materials following the low base set by earnings recessions in earlier years (Exhibit 2). Technology, led by hardware manufacturers in Taiwan and South Korea and by internet companies in China, has also enjoyed a very good year. While the impressive headline numbers would be hard to sustain over the next 12-18 months, we do expect more sustainable and evenly distributed earnings performance over that time. For example, higher interest rates and stronger economic activity should boost the earnings of Asian banks and improve credit quality. A stronger jobs market will likely raise consumer spending and demand for health care. Elections (scheduled or potential) could also accelerate government spending and infrastructure investment. This is a critical foundation for our constructive view on Asian equities. A more even distribution of earnings this year? EXHIBIT 2: EARNINGS BY SECTOR NEXT 12-MONTH CONSENSUS EARNINGS PER SHARE, USD, JAN 2011 = 100 200 180 160 140 120 100 80 60 40 Tech Health care Utilities Financials Staples Telecom Discr. Indust. Energy Materials 20 0 '11 '12 '13 '14 '15 '16 '17 '18 Source: FactSet, MSCI, J.P. Morgan Asset Management. Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 31/1/18. 2 ASIAN EQUITIES: MORE ROOM TO RUN?
Valuations: Currently reasonable, less of a concern to long-term investors Some sceptics argued that Asian equities are now expensive due to the momentum seen in 2017, which resulted in record highs for many stock indices. This view fails to take into account the underlying corporate earnings improvement compared with the period immediately before the 2007/08 Global Financial Crisis. This is just a different way of saying that the price-to-earnings (P/E) ratio now is cheaper than in 2007/08. The earnings per share (EPS) of MSCI Asia ex-japan index as of February 26 was 42.4% higher than the peak 2007, while the index level was only 7.9% higher (Exhibit 3). Historical peak to trough comparisons aren t unfavorable to current levels EXHIBIT 3: MSCI AC ASIA EX-JAPAN INDEX 900 Characteristic Feb 2000 Oct 2007 Feb 2018 Index level 349 687 741 800 P/E ratio (fwd.) 15.9x 17.3x 13.1x EPS (fwd.) 20.4 39.7 56.5 700 Dividend yield 1.4% 1.9% 2.0% 10-yr U.S. Treasury 6.6% 4.4% 2.7% 600 500 400 +325% -66% +232% 300 +155% -54% 200-66% 100 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 '18 Source: FactSet, MSCI, J.P. Morgan Asset Management. Positive yield does not imply positive return. Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 26/2/18. Moreover, valuation should be less of a worry for long-term investors. MSCI Asia ex-japan 1-year and 5-year returns from different starting valuations (Exhibit 4). An investment made with a starting P/E ratio within the range of 13 to 14 times returned an average of 4% after 1-year return and generated a positive return 58% of the time. This performance improved significantly to 8.2% on a 5-year annualized basis, with almost all generating a positive return. Hence, Asian equities do reward long-term investors, including those who are seeking income and take full advantage of the compounding effect by reinvesting dividends back into their Asian equity allocation. Current valuations should not be a cause of concern EXHIBIT 4: FORWARD P/E AND SUBSEQUENT RETURNS MSCI AC ASIA EX-JAPAN TOTAL RETURN INDEX 100% 80% 60% 40% 20% 0% -20% -40% -60% 5-year annualized -80% 8x 9x 10x 11x 12x 13x 14x 15x 16x 17x 18x Source: FactSet, MSCI, J.P. Morgan Asset Management Returns are 12-month and 60-month annualized total returns, measured monthly, beginning December 31, 1999. Past performance is not a reliable indicator of current and future results. Data reflect most recently available as of 31/1/18. 1-year J.P. MORGAN ASSET MANAGEMENT 3
What can go wrong? Given that our optimism on Asian equities is built upon the ongoing health of the global trade cycle, weaker global growth and protectionism are obvious threats. However, given the current growth momentum globally, upside risk to inflation is more likely than recession in the next 18-24 months. The risk to Asian equities (instead of recession) could therefore come from a much more aggressive Federal Reserve (Fed) when it comes to monetary policy normalization. Instead of 3 to 4 rate hikes in 2018, a faster pace of policy rate rises, induced by surprisingly strong inflationary pressure, could unsettle the global equity market, including Asia. This could also potentially bring back a strong U.S. dollar, which historically is a headwind to emerging markets and Asia. A strong U.S. dollar environment could put more pressure on EM and Asian central banks to raise interest rates in tandem with the Fed to protect their own currencies, especially for those with current account deficits. However, we expect U.S. inflation to grind higher in a gradual manner, instead of a sharp spike, and the Fed should have sufficient leeway to communicate with the market to prevent knee-jerk reaction. As for protectionism, Washington has already fired its opening salvo with tariffs on imports of solar power panels and washing machines. China has retaliated with an anti-dumping investigation into imports of sorghum, used for feeding livestock, from the U.S. The next flash point could be the result of the U.S. Section 301 Intellectual Property (IP) Investigation, under which the U.S. is accusing China of IP theft from U.S. companies operating in China. However, we expect any trade tensions to be product or sector specific, and don t see a comprehensive tariff on all Chinese exports to the U.S. Punitive tariffs on a broad range of Chinese exports to the U.S. could exacerbate the risk to inflation in the U.S., which would hurt consumers. Putting the whole story together We believe the outlook for Asian equities remains constructive for at least the next 12-18 months. The big difference in return performance between 2017 and previous years has been earnings (Exhibit 5). Although 2017 s earnings growth was artificially boosted by a low base and will be hard to duplicate, the current global growth momentum would imply that the current market consensus of 10-12% earnings growth for the next 12 months is reasonable. As for valuations, the current levels are in line with long-term averages. This implies that there is some buffer to absorb short-term shocks. Earnings have driven last year s return EXHIBIT 5: RETURN COMPOSITION MSCI AC ASIA EX-JAPAN 50% 40% 30% 20% 10% 0% -10% -20% -30% Currency Effect EPS Growth Outlook Total Return USD 2011 2012 2013 2014 2015 2016 2017 Source: FactSet, MSCI, J.P. Morgan Asset Management Data reflect most recently available as of 31/1/18. Multiple Expansion Dividend Yield 4 ASIAN EQUITIES: MORE ROOM TO RUN?
Table 1 provides a simple tool to consider the relationships among price index return, earnings and valuations. As of February 26 2018, MSCI Asia ex-japan EPS was 56.5 with a forward P/E ratio of 13.1 times. The vertical axis reflects the varying level of EPS and implied change to the index, whereas the horizontal axis shows the level of P/E ratio. We chose a range of 10 to 17 times since this represents the minimum and maximum P/E ratio in the recent decade. Hence, by applying EPS growth and valuation assumptions, investors can have a more clear idea of the magnitude of returns. For example, if the current market consensus on earnings growth of 10-12% is correct and the index enjoys a modest valuation re-rating to 14 times, it would imply a return of 17.3%. Note that this does not take into account dividends, currency effects or alpha generated by active stock selection. Possible implied index scenarios TABLE 1: IMPLIED RETURN DIFFERENCE % CHANGE 12-month forward earnings 12-month forward P/E 10.0 12.0 13.6 15.0 17.0 45.2-38.2-25.8-19.0-7.3 5.1 50.9-31.3-17.6-10.0 3.1 16.8 56.5-23.7-8.4 0.0 14.5 29.8 62.2-16.0 0.8 10.0 26.0 42.7 67.8-7.6 10.8 21.0 38.5 57.0 Source: J.P. Morgan Asset Management Data reflect most recently available as of 31/1/18. For Asian investors, local market strength in 2017 has weakened demand for diversification. Yet we see benefits in taking advantage of the diverse opportunities in Asia by investing across the region, rather than in one or two markets. There are also a variety of strategies available to meet investors financial objectives. We believe the current growth environment favors those investors that have a bias towards companies and sectors that can reap the benefits of this expansion phase, such as financials and companies related to the demand from Asian consumers and for better infrastructure. However, more conservative investors may also opt for income generation by looking out for companies that offer high dividend opportunities along with attractive levels of earnings growth. For international investors, Asian equity markets typically represent a high beta trade in the global equity sphere and deserve to be part of their portfolios, albeit with higher volatility relative to developed markets. In-depth research and insights to fully understand the industry landscape and corporate governance philosophy can potentially enhance their returns via additional alpha generation. Investment implication The outlook for Asian equities remains constructive, and we believe there is more room to run. We consider the market volatility seen in early February to be an overdue consolidation after a strong run in 2017, rather than the end of the road. The global trade cycle is enjoying strong momentum, which is a key pillar to our optimism on solid earnings growth. Valuations are in line with long-term averages, and this provides some cushion against the return of market volatility globally. We are conscious of some risk factors, including an inflation spike in the U.S., which could potentially lead to a more aggressive rate hike schedule by the Fed, and the threat of protectionism, which could undermine the trade cycle. However, we think the probability of these high impact events taking place is low. J.P. MORGAN ASSET MANAGEMENT 5
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