In our latest CIO Day, we revised our EM Asia growth outlook down to 7.3%. Many Asian countries continue to struggle with high numbers of COVID-19 infection cases and a lag in vaccination rate. North Asia’s zero tolerance stance towards Covid-19 also caps any recovery, especially in service consumption as border controls and sporadic lockdowns prolong business pains, restrict social activities and dampen consumers' confidence. In China, strict policy measures such as travel restrictions, quarantine orders, and closure of entertainment venues and shipping ports were implemented after the emergence of a new delta variant wave that spread over sixteen provinces in China.
Having said that, we see some light at the end of the tunnel. Recent resurgence in new waves of virus has incentivised Asian governments to accelerate its vaccination program. We see significant progress in China where its vaccination rate has surpassed those in developed countries and China is looking to introduce a third booster shot for its citizens for higher protection. In some Asian countries, such as India and Indonesia, immunity level is rising despite low vaccination level due to past high infection rate, which allowed for a continued recovery of activity.
We expect a lower growth in China in the upcoming quarter and have revised 2021 growth to 8.2% down from 8.7%. Uncertainty over tighter regulation on its internet, education, and real estate sectors, along with softer economic data in July, point towards a possible faster-than-expected slowdown. Nevertheless, we believe growth should stabilize along with a catch up in consumption in the fourth quarter this year, driven by more pro-active and targeted fiscal support by the Chinese government, ongoing strong growth of disposable income, higher employment and positive vaccination progress. Monetary policy should remain accommodative within China, and more reserve requirement ratio (RRR) cuts are expected. However, key rate cuts would not be expected as the Chinese authorities are wary of systemic risks, financial bubbles and the need for de-leveraging. Moving into 2022, we expect a return of lower growth potential with growth at 5.6% due to post-Covid normalization, shift in government’s priorities towards common prosperity and a more balanced and sustainable growth ahead.
Due to the new Covid-19 wave in second quarter, we revised India and ASEAN 2021 growth down to 9.3% and 4.0% respectively. While cases remain high, we have observed significant improvement from its peak in May and June. We think the worst of the pandemic-related downturn is over. With continued progress on vaccinations, we expect further re-opening of these economies in the later part of the year which should result in a catch up in consumption and gradual recovery in badly hit service sectors.
Emerging Market Asia equities
MSCI Asia ex Japan Index has underperformed MSCI World by 26% year to date with MSCI China as the main detractor which was down 30% against MSCI world.
The underperformance could be explained by
- the decision to tighten monetary policies by the People's Bank of China (PBoC) ahead of the other central banks early this year after an impressive first quarter growth of 18.3% year-on-year and a strong China equity market into mid-February.
- lower delta growth relative to the rest of the world resulted by ongoing high Covid-19 cases and zero case policy;
- regulatory crackdown in China which rattled investors' sentiment.
The recent regulatory crackdown within China led to a huge correction in the Chinese market. MSCI China index has lost 12% this year and the CSI China Tech Index is currently down almost 60% from its peak. While the regulations are arguably backed by clear policy intentions and social merits, the unexpected scope and velocity of the announcement of regulations left investors thinking that the Chinese government has declared war on its private sector. We do not believe this is the case as the private sector plays an important role in China’s goal of accelerating digitalisation and innovation.
We believe the recent regulatory efforts are aimed at reforms that are important to drive more sustainable and balanced growth in the longer term, foster fairer competition which is crucial for innovation, and lower systemic risk in the highly leveraged sectors. The regulatory overhang should remain for the next twelve months but with less negative impact on the Chinese equity market as investors have started to factor in the regulatory uncertainty. While valuations look attractive relative to a year ago, we stay cautious and underweight Chinese internet equities as the outlook for Chinese internet sector is likely to remain murky in the next six months due to high uncertainty over the development within China's regulatory landscape and its impact on affected companies’ growth, profitability and risk premium.
For Chinese equities, we prefer A shares to MSCI China as they are less exposed to regulatory risk and could benefit from upcoming policy easing. Policy friendly sectors such as renewables, electric vehicle, semiconductor, and industrial automation which are aligned with the national development objectives should continue to enjoy government support and are likely to face less policy risks. Outside of China, investors could shift their attention to new economy stocks in the rest of Asia which face less regulatory risks and are likely to benefit from a pick-up in U.S. growth.
With a significant improvement in Covid-19 cases, we could expect a positive cyclical recovery in India driven by improving pace of vaccination, pent up demand, and robust export growth. A similar picture can be seen in the ASEAN markets which underperformed the region significantly this year due to ongoing high Covid-19 cases and prolonged lockdown. However, this chronic underperformance is coming to an end as restrictions are easing along with declining new cases. With low valuations and additional policy support, ASEAN the late joiner to the cyclical rally, presents attractive opportunities to investors to participate in the reopening trade.
Amidst the high uncertainty within Chinese regulatory landscape and Asia’s underperformance, we remain positive on Asia in the medium term. Asia has accumulated less debt relative to developed countries during this crisis. Accelerating digitalisation trends provide a solid foundation for future performance. U.S. equities had an incredible run so far leading to almost 35% premium over Asian equities, higher than the average discount over the past 20 years. We could see a reverse in trends next year with the rest of world moving towards tighter monetary policy driven by strong recovery and inflationary pressure while China increases fiscal spending with more liquidity provision.
Asian Fixed Income
The risk-off move is not confined to the equity market. Both Asian credit and the Chinese Yuan were also under pressure in the past month.
Despite recent volatility in the Chinese market, we remain constructive on the Chinese Government Bond (CGB), which presents an attractive yield pick-up versus U.S. Treasury Bonds and provides diversification benefits due to its low correlation to a wide range of asset classes. We expect the Chinese Yuan to be well-anchored in the next 12 months, providing a good support for the CGB. The inclusion into global indices and liberalisation of Chinese capital market with the bond connect would also help to promote healthy inflows.
For Chinese credits, we need to be selective. On the one hand, market volatility within the Chinese property market is likely to remain high and susceptible to negative news on individual credits in the near-to-medium term. Concerns over China’s regulatory overhaul continue to weigh market sentiment and have led to higher risk premiums on Chinese High Yields. On the other hand, Chinese government has been guiding resources towards sectors (e.g. semiconductor related industries, advanced manufacturing etc.) that play important roles in its strategic priorities such as green development and self- sufficiency as outlined in the Five Year Plan. Hence, we believe selected credits from these policy friendly sectors should remain supported in the foreseeable future.
We remain positive on Asian Credit market which is supported by carry and high global liquidity. Compared to Developed market credit, Asian credit offers better returns. Asian credit also has better risk profile compared to Emerging market fixed income. Regulatory overhang, along with idiosyncratic risks within the Chinese property and financial sectors which have led to an adjustment of risk premia recently. Valuation is attractive after the largest monthly spread widening year-to-date. Hence, we could expect some tightening from current levels. In view of tapering in the next few months, we could expect higher volatility in the fixed income market. Our preference is for investment grade and shorter-dated high yield issuers, and we are reducing exposure to higher beta names in the short term.