2 November 2017

Despite the flare up of dangerous geopolitical risks, Asian assets have performed exceptionally well in 2017.  Indeed, after years of underperformance, the 28% gain in Asian equity markets is twice that of the S&P500.  Likewise, shrugging off initial concerns after last year’s US election, most of the region’s currencies have appreciated handsomely in 2017.  However, Asian markets will confront important challenges in the year ahead.  In need of a political victory, President Trump likely will use his upcoming regional visit to confront bilateral trade imbalances.  Previously, protectionist rhetoric contributed to volatility in Asia’s trade-dependent markets.  In addition, rising US interest rates and an eventual renewal of concern about weaker economic growth in China could pose risks for Asian equity and FX markets.  On the eve of President Trump’s first visit, how will Asian markets confront these headwinds?

Will the Fed End Asia’s Party?

As outlined in an earlier blog, the US Federal Reserve has a credibility problem.  Despite outlining its plan to raise interest rates 4 times prior to the end of 2018, the US bond market has only discounted about half that amount.  The market’s scepticism is understandable: in both 2015/16 the Fed pledged similar rate hikes, but delivered only one per year.  In 2017, however, the Fed has delivered the pre-announced 3 rate hikes, even though inflation has been lower than expected.  I expect the Fed will deliver its planned monetary tightening again next year.  As the market has not discounted this outcome, this will be a negative surprise.

Historically, tighter US monetary conditions are a headwind for Asian markets.  Will this time be any different?  The favourable fundamentals that fuelled this year’s rally look set to continue.  Despite the slowdown in China, regional economic growth remains both healthy and broadly-based geographically.  For example, GDP advanced over 6% in most of the region, and even the more mature economies (i.e. Korea, Taiwan, and Thailand) expanded by 4%.

Equally importantly, the expansion is well balanced.  Domestic demand has remained solid, with both consumer spending and business investment recording healthy gains.   And, the trade-oriented Asian economy has benefited from the recent acceleration in global growth and trade flows.  For example, exports have advanced nearly 20% virtually in all Asian nations, and even Japan registered a 15% gain.  By comparison, US overseas sales advanced a more modest 6%.  Recent evidence suggests these trends will continue as both global business investment and technology spending are accelerating.  Eports from tech-giants Korea and Taiwan have been especially strong this year, up 24% and 18% respectively. Most recently, Korea posted a 36% increase in exports in September!

Furthermore, as in much of the world, Asian inflation remains low. Indeed, reflecting lower-than-expected price gains, the IMF sliced recently its 2017 Asian CPI forecast by a significant 0.7% (to 2.3%).  And, surprisingly low price pressures are widespread.  Indeed, in India, Indonesia, Viet Nam, Korea, Thailand, and Taiwan inflation is lower than a year ago, despite stronger-than-expected growth.

Furthermore, despite this year’s surge in stock prices, equity market valuations do not appear overly stretched.  Corporate earnings are still below previous peak levels (by comparison US earnings are 25% above the peak of the last cycle).  And, reflecting the economic backdrop, profits should advance 12-15% in 2018.  Various metrics suggest that Asian valuations are now only approaching levels in line with historical averages, so not extreme.  Moreover, Asian stocks still trade at a 30% discount to world markets – 10% more than the historical average. Likewise, Asian stocks are still cheap compared to bonds. Specifically, the gap between Asia’s earnings yield (inverse of the P/E ratio) and US bond yields is two percent above the long term average, which provides a cushion as US yields rise towards 2.75%.

These relative valuation metrics suggest Asia should be better able to withstand higher US interest rates compared both to history and to other global equity markets. However, with Asian inflation still low, regional monetary policy will remain on hold, even as US rates rise.  This policy mismatch is likely to result in some weakness in many Asian exchange rates.  As most Asian currencies are linked to the USD to a degree, greenback strength is normally a headwind for Asian equities (as exporters lose competitiveness in third markets). Given this year’s appreciation in regional FX, however, Asian central banks are less likely to resist modest currency weakness, which may provide a further buffer for stock markets as US monetary conditions tighten.

President Trump: Progress on Trade – Careful What You Wish For!

No one will be surprised that President Trump will want to address bilateral trade issues during his maiden visit to Asia.  To be sure, Asia overall has a modest current account surplus of only  2% of GDP, and certain large countries like India and Indonesia run external deficits.  On the other hand, Singapore, Thailand, and Taiwan experience surpluses of 10-20% of GDP!  China, Korea, and Japan will be the focus, as all three run large surpluses with the USA, and account for over 60% of America’s overall trade deficit.

What can we expect?  First of all, the US President’s room to maneuverer is limited.  Against the backdrop of the crisis in North Korea, the US leader’s top priority will be to reassure these three nations of America’s commitment to the region.  To be sure, developing a strategy to deal with this crisis will involve some tough diplomacy, especially with China.  However, it would not be in America’s interest to provoke a trade conflict with key allies at this time.

In addition, Asia has been the largest contributor to global growth in recent years.  Indeed, while the US economy has been growing only 1.5% annually during this economic cycle, Asia has been consistently growing above 5% since the financial crisis.  Moreover, US exports to Asia account for over 25% of American sales abroad.  These three countries account for 60% of sales to Asia, and have grown 15% during the past year compared to 6% for overall American exports. Of course, the trade relationship is a two way street: exports to the USA from these three nations represent 15-20% of their sales abroad.  Again, a trade dispute with rapidly growing trading partners is not in America’s interest or that of a President pledged to job growth.

Are misaligned exchange rates playing a role in America’s trade imbalances with Asia?  Measuring the correct underlying value of currencies is not easy; however, Chart 1 uses BIS data to compute the deviation of each exchange rate’s deviation from its long term average (positive results indicate overvaluation).  Rather than being dramatically undervalued, most Asian exchange rates are near their long term averages.  Japan is an exception.  After a protracted period of deflation, the yen does appear undervalued. On the other hand, the Chinese RMB has appreciated over 25% in real terms since currency liberalisation a decade ago.

The Trump team, however, does have a point. Chart 2 illustrates the ratio of USA’s exports/imports of goods and services with its key trading partners.  Overall, the level of US exports is 80% of the level of imports (producing a world-wide deficit).  Europe (Germany is an exception), Mexico, and Canada have similar or better than average results.  On the other hand, the low ratio for many Asia countries indicates the penetration of American products into some Asian markets is much less than their ability to sell in the USA.  Interestingly, Korean and Taiwan are not out of line, but American penetration into Chinese (especially) and Japanese markets is decidedly subpar (also India, Thailand, Malaysia and Viet Nam).

Of course, there are many reasons for these patterns.  And, as I have discussed in past blogs, trade imbalances result from macro factors, particularly the level of each nation’s level of savings compared to investment (and rarely from “unfair” trade). America’s persistent trade deficits reflect its paltry level of savings. Imposing protective tariffs on the goods of individual countries will only shift American spending to the goods of other nations.  Bilateral balances may be affected, but the overall deficit will only be reduced by increasing American savings (reducing the budget deficit or increasing household thrift).  Even convincing other countries to import more American goods would only lead to higher US inflation, unless accompanied by lower US consumption.

On the other hand, Asian surpluses reflect their high savings rates:  China 45%, Korea 36%, and Japan 27% compared to 18% in USA.  The focus of American diplomacy, therefore, should be to “persuade” Asian nations to both reduce savings, increase investment, and liberalise their markets for services, tech, health care, media, etc. in which the USA enjoys a significant comparative advantage.

To be sure, there will be objections. China has succeeded already in reducing its savings rate from 50% in recent years, and will argue that they have only a small current account surplus.  It is beyond doubt, however, that the very low US penetration rate into the Chinese market reflects formidable non-tariff barriers on these key American sectors.  Both Japan and Korea have huge investment and infrastructure needs, and aging populations will soon begin dipping into their savings.

Despite President Trump’s wish for a quick fix to trade issues, geopolitical considerations will constrain American trade ambitions.  The three Asian trade heavyweights, however, would help defuse potential tensions by stepping up their efforts to reduce savings and liberalise domestic markets; thereby, allowing greater penetration by American firms.

China: Risks Emerge, Watch Capital Outflows

Asian markets have benefited this year, as fears of slowing economic growth in China receded. In future blogs I will detail my thoughts on China’s structural growth deceleration and its potential impact on other Asian nations.  For now, I believe concerns about Chinese deleveraging and growth will eventually return now that the Communist Party Conference is over.

Timing will be difficult, but capital flows will provide warnings.  Chart 3 illustrates that in the 15 years following the Asian crisis, regional central banks took advantage of large capital inflows and current account surplus to increase their stockpile of reserves by $1.3 trillion.  China alone accumulated an additional $3 trillion.  Next time a crisis (or a hedge fund speculator) arrived, they would be prepared!

As the Chinese RMB weakened during 2014-16 – the “China Tantrum”— capital left the region: international reserves remained unchanged during this period despite large current account surpluses.  China’s reserves alone declined $450 billion!  The strategy of monetary authorities worked, FX declined only 5%, and most recovered.  However, Asian equities underperformed the S&P500 by 50%!

Capital inflows returned in 2017: Chinese reserves are up $110 billion and an additional $170 billion in the rest of the region. As we have seen, the huge stockpile of reserves (now $3.3 trillion, excluding China) helps cushion the blow, but when China catches cold, you know what happens!

Strategic Implications

• While rising US interest rates pose a risk, the combination of healthy growth, low inflation, easy monetary conditions, and relatively cheap valuations will lead to the outperformance of Asian markets relative to the S&P 500. However, the gap will be far less than in 2017.
• The monetary policy mismatch will lead to modest USD dollar strength against most Asian currencies (the USD will strengthen more than implied by current interest rate differentials). The Japanese yen will be the weakest of the G3 currencies.
• China represents the most serious of the three risks in the year ahead.