15th April 2014
Asian equity markets have lagged their developed market peers over the last twelve months as China – its biggest and most significant economy – has disappointed. Stuart Parks head of Asian equities at Invesco Perpetual, looks at whether China is poised for transformational reform and observes some encouraging signs within the region…
This issue of China continues to dominate the Asian investment landscape. However, before looking at whether its economy is structurally flawed or poised for transformational reform, it is worth recognising some positive developments that have been taking place elsewhere in the region.
Last year there were worrying signs of overheating in several South Asian economies, with high wage increases, rising inflation and deteriorating current account positions. These pressures were most evident in India and Indonesia, where rising cost pressures saw a loss of competitiveness and deterioration in export performance. However, since then, monetary policy has been tightened, inflationary pressures have subsided and current account deficits have narrowed. The speed of adjustment has been encouraging, dispelling concerns of a repeat of the 1997/98 Asian crisis. Consumer demand has slowed, but its long-term structural growth drivers remain intact, and there have been improvements to export competitiveness across the region.
Another issue for us in recent years has been the generally over-optimistic nature of corporate earnings forecasts. For the last three years, expectations at the start of the year have been far too high, and actual earnings growth delivered has fallen short, which has been a headwind for equity markets. Current forecasts for 2014 are lower than they have been in recent years (see Figure 1), and are more realistic in our view – another significant and welcome adjustment.
Source: Invesco, Goldman Sachs earnings forecast data for MSCI AC Asia Pacific ex Japan index as at December 2013.
China’s reform agenda
However, China’s economic and equity market performance have disappointed. This has largely been due to concerns over China’s ability to move away from its unsustainable reliance on credit-fuelled investment, particularly in infrastructure and real estate. In the period since the global financial crisis, China’s debt-to-GDP ratio has increased from around 120% to 220%, with much of the debt financing projects of questionable profitability. The Chinese government recognises the potential threats posed by a build-up of bad debts, and overall credit growth is coming down, but it is still much higher than nominal GDP growth.
Last November’s announcement of an ambitious new reform agenda gave us grounds for optimism – particularly initiatives focused on allowing market forces a more ‘decisive’ role in the allocation of resources, improving capital allocation and shifting income towards households. The Party leadership appeared to go out of its way to explain why wide-ranging reform is needed, and we believe there is real potential for meaningful change in the medium-term.
If they are to succeed in implementing some of these reforms then we would expect to see a huge reallocation of capital to successful, profitable enterprises, particularly in the private sector. This could be revolutionary. It would leave undeserving companies, many of which are state-owned enterprises (SOEs), to be closed, with assets sold off and workers redeployed. There is no denying that this is a monumental challenge; but China has been here before with the successful restructuring overseen by Premier Zhu Rongji in the late 90s and early 2000s, when huge swathes of workers were laid off and reallocated to the export manufacturing sector. This time around, excess capacity needs to be shifted towards the services sector, where the private sector has greater involvement, and where profitability levels and investor returns tend to be higher.
The critical question is whether the authorities are prepared to let growth drop below their 7.5% growth target as they try and implement reforms (see Figure 2). My chief concern is that they are not prepared to make this potentially painful adjustment, preferring instead to try and smooth the transition. Recent economic data has pointed towards a further slowdown in China’s economy, albeit data that is distorted by the effects of the Chinese New Year, but the authorities have resolutely stuck to their minimum growth target, raising expectations of further questionable investment spending.
Until we see evidence of reforms, scepticism over China’s resolve to rebalance its economy and ability to control credit growth will remain a headwind for markets in the region. However, China has proven in the past that it can change quickly when challenged and there have been encouraging developments in other economies across the region. In our view, now is not the time to despair about China and the region in general as we believe that very little hope is being reflected in market valuations. Earnings growth expectations of 10% for the region in 2014 look achievable to us and we are still able to find what we consider to be good-quality companies at attractive valuations.