Asia: the case for quality

2022 was a year of rising inflation and rising interest rates. Quality stocks were expected to outperform in such a climate. This would fit the historical trend – quality stocks have outperformed the broad market over the past 40 years during periods of elevated inflation. However, this was not the case last year, as fundamentals fell by the wayside.

An extraordinary confluence of geopolitical risks and rising inflation proved too strong, pushing valuations downwards. However, fundamentals were not truly tested in 2022 as interest rates were still low for much of the year, allowing even companies with weaker pricing power to pass on costs. Value stocks (these being companies considered undervalued by the market, thereby representing a buying opportunity) rose sharply as a result. Growth stocks were disproportionately sold off. Even stocks with quality attributes like strong balance sheets and consistent profitability were caught up as investors rushed to address underweights to value.

Earnings resilience will be the key differentiator this year

We expect this year to be different. We see quality returning to the fore, as rising inflation and or higher interest rates persist. Only fundamentally strong companies will be able to pass on costs and they will need to make a higher return on assets, to counter the impact of rising costs and price pressures. This means that pricing power, competitive advantage, balance sheet strength and free cash flow will be in focus. Under an environment where financial stress could rise, companies that have strong balance sheets, low or minimal leverage and an ability to generate steady free cash flow will be more resilient than those which are highly geared, have frail balance sheets and weak market positioning. We expect quality companies to outperform this year. We define such companies as those having a sustainable competitive advantage, superior financials, solid management execution and track record as well as an ESG focus that are operating in industries with attractive characteristics. More broadly, as a region, Asia has the edge, too. At the government level, lessons from the Asian Financial Crisis have been well learnt. Emerging Asia, in particular, has the lowest level of government debt to Gross Domestic Product when compared to the US, Eurozone and the UK, as governments paid closer heed to currency stability and fiscal discipline. At the corporate level, companies listed in the Asia Pacific ex Japan region, too, stack up well against their counterparts in Europe, Japan and the US, with the lowest net debt to equity ratio across the pack. Historically, recessions have been accompanied by earnings downgrades, and earnings dips typically precede quality outperformance. 2022 was a year of extreme multiple compression, with US indicators increasingly flashing recession warnings. Towards the end of 2022, US dollar weakness alongside the Federal Reserve’s slowing of policy rate increases and China’s faster than- expected re-opening meant we finished the year at a potentially interesting inflection point. At this point, already well into 2023, we are seeing a recovery in valuations across Asia, with markets taking a ‘first-in-first out’ approach. With valuations no longer depressed, especially on a price to earnings basis, this implies that the next leg of returns would depend on earnings. Thus far, we have seen significant cuts to consensus earnings estimates for Asia, with Korea and Taiwan tech suffering the deepest cuts.

Separating the strong from the weak

We still expect some pressure on earnings this year, which would separate the strong from the weak. Companies having high free cash flow visibility and rock-solid balance sheets are likely to be the ones to give investors resilient and relatively higher returns. As China opens up, the recovery in domestic consumption and industrial conditions is likely to benefit Asia, owing to a rebound in demand for exports, services, travel and intra-regional trade. China’s reopening could boost tourism revenues in ASEAN member states particularly, given the significant contribution of Chinese tourist dollars to those economies. All this would be a near term catalyst for earnings to improve across Asia.

The market drivers have changed

We believe Asian and emerging markets are well placed looking ahead, with fundamentals and valuations looking attractive in a global context. We also believe the market drivers have changed. There are strong forces at play that will mean higher costs, and higher prices, for some time to come. The Covid pandemic laid bare the vulnerability of the global supply chain to disruptions and lockdowns. Add to that a backdrop of increasing geopolitical uncertainty and complexity in the Ukraine war, and the tussle for technological dominance between China and the US that has had great impact on the semiconductor industry.

China in the driver’s seat

All this has meant that regionalisation of the global supply chain has started as well as increasing localisation and even re-shoring strategies to ensure that sources of supply are diversified, products are customised closer to target markets and co-located supply ecosystems are developed. In turn, this increases costs for companies, and prices for the end consumer. Companies with pricing power, a competitive advantage and strong distribution will be the winners. While this will make the global economy less efficient overall, emerging and Asian countries should benefit as large, more complex global supply chains will create more jobs and faster domestic growth.

Such developments also mean companies need to invest more in supply sources including manufacturing facilities across more locations to de-risk the supply chain. This capital expenditure is only going to increase as we face a necessary period of investment to combat climate transition challenges. Policymakers globally are committing to a greener and lower-carbon world, and China is in the driver’s seat as investments in renewable energy, batteries, electric vehicles, related infrastructure and environment management all have a bright future. Its green transition has created giants that are able to compete on the global stage.

Such a series of events may well initiate a period of relative strength for Asia, where returns have lagged that of the US over the past 10 years but are showing signs of a bottoming and starting to improve.

Looking ahead to a more resilient Asia

Risks have shifted from last year’s interest rates and inflation concerns to recession, and we expect quality to outperform as it has done in past recessionary conditions. Having tightened further on quality and focused on pricing power, we believe that our portfolios are positioned well for the current environment.

While Asia is unlikely to be immune to recessionary risks in the developed markets, the strengths of Asian companies and governments reopening tailwinds, particularly in China, and supportive valuations should help Asia to be more resilient this year. We expect China internet – where valuations, are still not stretched – to see three-pronged benefits of 1) reopening; 2) easing regulation; and 3) a newly developed focus on shareholder returns. The reopening will spur direct segments like online travel and local services as well as indirect ones like e-commerce and eventually advertising.

Globally we are also seeing plans for capital expenditure spending picking up, in part as we see a reconfiguration and diversification of supply chains, along with infrastructure investment, and this also bodes well for relative performance in Asia.

Find out more at invtrusts.co.uk/asia