How much tension will the shift to the most important economy from the USA to China bring? What impact will the trade conflict in 2020 have on the international financial markets? Robert Horrocks, CIO of Matthews Asia, gives an outlook.
AsiaFundManagers.com: In 2019, we saw mainly politically influenced stock markets. Do investors have to be prepared for the possibility that this will remain unchanged in the long term?
Robert Horrocks: 2019 has been a very political year. It has mostly been the trade politics between the US and China that people worry about. That is not going away. Think of the US as a declining empire and China as a rising empire. There are always going to be tensions there and I expect to see the market deal with that over time. I do think there is a deal to be done, that China wants to give access to the financial markets. Its number one domestic policy is to institutionalize its own financial markets and I think there’s a deal to be done on intellectual property rights as well, but it’s going to take time.
AsiaFundManagers.com: What short, medium and long-term effects will the trade conflict have on growth in Asia?
Robert Horrocks: Trade and growth are not that important from a GDP perspective. I don’t think the US can isolate or contain China by using these trade tariffs, this trade-war method. China is reaching out across Asia and Central Europe; it is now investing in Italy and Greece. If the US tries to contain or isolate China, it will be isolating itself from the rest of the world.
The importance of trade is less about GDP growth, it is about how China manages an aging workforce, how it moves labor intensive jobs into South-East Asia, how it builds up economic relations with its neighbors, and how it creates greater efficiencies. But it is not going to add much to GDP growth, per say.
AsiaFundManagers.com: In a recent report, you come to the conclusion that capital and resources are being used more efficiently in Asia. Why is that?
Robert Horrocks: I do believe that capital is going to be used more efficiently in Asia over the coming years and decades, and it will be primarily China doing this. They have gone from an economy based upon manufacturing -building out physical infrastructure, to moving into a service-led economy. China wants to build all of the things that we are used to in Europe and the US, such as a welfare state and a financial center. It wants its treasury to be recognized worldwide as a safe-place to park money, and it wants the renminbi to be an international currency. It wants all the efficiencies of a capital market to help support a pension system, and so that has been their number one focus. Better corporate governance, more efficient institutions around the stock market, building the trust of both international and domestic investors, these things are very important for China.
AsiaFundManagers.com: When it comes to evaluation, what can we currently say about the valuation of Asian equities? And what is the most underestimated investment class?
Robert Horrocks: Looking at valuations just using a ‘price to earnings’, Asia looks relatively cheap compared to the US – about the same as Europe. However, there is a big thing underlying that earnings number. During the last decade in Asia, labor, i.e. the worker, has gained the greater share of economic growth, and that is totally opposite to what has been happening in Europe and the US. In the US and Europe there have been expanding margins, whilst in Asia those margins have been crushed. Those valuations are actually overestimated in Asia and underestimated in the US. But I think that Asia is not just trading at a twenty-percent discount, but when you think about normalized earnings, that is probably nearer a thirty or thirty-five percent discount at the US. It is probably at a discount to Europe as well.
As for what is the most underestimated part of the market? It is probably the small and mid caps. In the first ten years of this century small to mid caps did very well – growth was strong. In the last ten years growth has been weak and the smaller mid caps have lagged. I believe this will switch back the other way.
AsiaFundManagers.com: Due to low interest rates, Asian bonds have moved into the focus of European investors. Where do you see the best opportunities here?
Robert Horrocks: We have just started to see an appetite for Asian bonds. It was never really a category before, just emerging market debt. However, people are starting to realize that within emerging market debt, Asian bonds actually are the better-quality bonds, particularly when it comes to corporates. If you look at spreads worldwide, corporate spreads over sovereigns, they are quite thin. In Asia they are still near average level. That is probably where most of the value is in the bond market in Asia.
AsiaFundManagers.com: What development do you expect for the Asian financial markets in 2020?
Robert Horrocks: In the near-term timeframe of 2020, looking at the financial markets around the world, the most important thing is how are those financial markets able respond to slower growth – whether it be slower growth in the US, in Europe or recession. The US can react with traditional interest rate policy, whilst in Europe, they will need to have more quantitative easing, probably even a coordinated fiscal policy, which looks tricky to achieve.
However, Asia looks well placed, as their economies have large current account surpluses and very low rates of inflation. They are well placed to use both fiscal and traditional interest rate policy to offset a slowdown. I believe this will be the theme of the markets in 2020. Watch the core inflation rate in Chin and Asia as a whole, as it starts to tick up, there will be a big operating leverage, then corporate earnings will start to accelerate very quickly.