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Marcuard's Market update by GaveKal Research
In the good old days, a US economic rebound would be an unambiguous, no-brainer buy signal for global assets in general, and high-beta Asian assets in particular. But today, of course, it’s complicated. Strong US growth only brings closer the day of reckoning: the start of the unwind of the biggest Federal Reserve balance sheet in history.
In this context, it is not surprising that Asian equities and currencies have responded with only cautious optimism to the recent string of strong data points from the US, including the news on Friday that unemployment is now the lowest in five years, at 7%. The explanation is obvious: these markets also have to digest the rising likelihood of imminent tapering of the Fed’s massive asset purchasing program. Expectations of Fed tapering beginning as early as this month have recently doubled from 17% to 34%, according to Bloomberg.
What does this mean for Asia? No doubt Asian assets remain vulnerable to another round of taper-related outflows; especially those countries with structural deficits. But valuations, growth potential and compelling structural narratives in China and Japan present powerful counter-forces to the liquidity concerns.
Moreover, there is reason to expect actualtapering may not kick up as much volatility as the prospect of tapering did. First, the starting point is very different than back in May. In the US, the long end of the bond market is already yielding some 100bps higher than before the “taper tantrum.” Meanwhile, inflationary pressures have continued to dissipate—indeed, even with growth rebounding, deflation remains a threat. As such, the Fed is in a much better position to manage monetary policy expectations, i.e., to couple tapering with convincing promises that short rates will remain anchored at zero for the foreseeable future. Given that fixed income volatility was probably the biggest cause for the Asian sell-off this summer, this has to be good news.
But what really intrigues us about Asia these days, is that the region’s two biggest economies are undertaking major structural reforms that will, in our view, increase the region’s earnings potential.
In China the policy drift of the past couple of years has given way to a pretty decisive supply-side agenda. Increased private sector participation will open new channels of economic activity, offsetting the impact of a gradual deflating of China’s investment boom. Individual reforms to back this program have been coming fast and thick. Last week, for instance, the People’s Bank of China said it wants to use the new free-trade zone in Shanghai to push ahead with greater liberalization of capital flows. Just yesterday, China issued rules for trading of certificates of deposit on the interbank market, another step towards more market-based pricing of money. News that a deposit insurance scheme is ready to be launched also filtered in. All these reforms are aimed at increasing China’s capital efficiency; as a result, its return on equity should also rise.
Of course, China is not the only major economy in Asia with a big reform program. Although Prime Minister Shinzo Abe’s “third arrow” of structural reforms has not yet hit its mark, we still believe there are reasons for medium-term optimism in Japan. If nothing else, the weakening of the yen should continue to provide a strong tailwind to corporate profits. The yen is now at 103 against the dollar and has surpassed 141 with the euro.
Asia’s valuation gap with the developed markets has grown too wide—this is largely due to tapering fears. With China and Japan offering very positive structural narratives, and with tapering already better priced into bond markets, investors need to ask themselves whether Asia’s “tapering risk premium” is about to fall.
