Equities: New norms for China valuations

Attractive valuations, less harsh regulation and the easing cycle of China’s monetary policy mean some managers may be turning positive on the country. Peter Guy speaks to two regional portfolio managers. Recent market turmoil has made asset managers consider what realignments in value lie ahead for China and Asia (ex-Japan) equities. And, it’s made them reassess traditional risk concepts that had taken a back seat in market analysis since the 2008 global financial crisis. “Asian equities are looking cheap against the US but expensive compared with Europe,” says Mike Kerley, Pacific Equities portfolio manager at Janus Henderson Investors. “We are seeing massive disparity in the markets between growth and value. The broad market doesn’t look cheap at 14 times earnings. But disparity is where relative value lies.” Price discovery used to act as a driving force in markets, all underpinned by the risk free rate. Since 2008, negative-to-low interest rates have distorted markets by encouraging financial bubbles. So, moving forward because of and in the face of uncertain inflation and interest-rate outlooks provides a refreshing return to traditional valuation models. Lei Wang, portfolio manager at Thornburg Investment Management, observes that the MSCI Asia ex-Japan index currently trades (at the time of writing) at a forward P/E multiple of 13.5, which is “exactly the average level of the past five years since 2017”. Over the past ten years since 2012, it has been 12.5x. “With this in mind, I would say valuations are fair, after peaking at 18x at the beginning of 2021. They’re also higher than the 10.5x trough we experienced during the most recent recession in 2018.” Wang adds: “While it may appear inexpensive, we have to factor in the cycle of increasing rates on the horizon. Adjusting for high discount rates, valuations are not cheap. If the Fed increases rates by 150bps, the P/E of the index could face downward pressure to an approximate 10x handle.” Kerley at Janus Henderson says that it could be argued that markets are entering a period of cyclicality. “Value tends to be more sensitive to rising rates and increased cyclical activity, while growth is negatively correlated, as discount rates increase and valuations look more stretched. The question is how long that lasts and whether it is sustainable, or whether we are at a point where inflationary pressures are transitory rather than structural.” Active investing is returning
Kerley, who works within the Asian dividend income strategy, adds: “Higher interest rates have yet to really kick in, but cash has been discredited as an asset for the last 12 years. The DCF [discounted cash flow] analysis was hijacked by growth sector stocks, because cash was basically worth zero. “I think we’re going back to a point where cash doesn’t become a worthless asset. Previous investment styles had migrated to a focus on revenue, not profits, which made them difficult to traditionally value.” He argues that Asia ex-Japan should be seen as a growth proposition and that looking at broad valuations of indices is misleading. “Stock-picking, active investing is returning.” But he also warns that investors need to “finally see” a return to a normalised, interest rate cycle. This will usher in a return to focusing on economic fundamentals rather than liquidity-fuelled asset inflation, he says, adding that a risk of current trends is a transition from inflation to asset deflation due to rising interest rates. According to Kerley, years of intermediating capital market has made the Federal Reserve become market-centric instead of focused on economic goals. “This bias drives its monetary policy and interest rates. If regular interest rate increases return, then negative real interest rates will occur, which is unhealthy. “At this stage of the cycle, yield curves should be steepening or shifting higher, but they have instead flattened. “If rates go up, and the short end goes up by 1% to 2%, the question will be whether we see a flattening of the curve – the best-case scenario – or whether it inverts. “Yield curve inversion is universally negative for risk assets, which is the major risk as we transition to a normalised interest rate cycle.” Tremendous implications
Wang reminds investors that China’s central bank, the People’s Bank of China, is another key focal point along with the US Fed, as the divergence of monetary policies between the largest economy and the second-largest economy has a “tremendous implication” for regional and global growth and risky assets. Risk-on or risk-off in markets will be driven by these key inputs in addition to “geopolitical blips which are generally short-lived. My asset allocation model, however, has not dramatically changed.” Despite continuing uncertainty linked to technology regulation reform and property debts, Kerley thinks “China is still investable. I think the key is to invest alongside the government and its policies and not against it. I don’t think the Chinese will ever stand in the way of innovation, but they stand in the way of scale and influence.” He adds: “We’ll continue to see regulatory tinkering, but I think most of it is over. Large Chinese technology companies won’t stop growing, but you have to value them based on the new norm, which is probably 10% to 15% growth rather than 20% to 30%. There are good companies out there that will continue to make money and be profitable.” However, the economy will pose challenges. “China will struggle to achieve 5% GDP growth this year. A turning point has been reached where regulatory lines have been drawn and the focus now needs to be on moving forwards towards self-sufficiency and innovation.” Kerley is clear about financial challenges facing China. “The private sector is key for China. After the new regulatory policies, it needs a forecastable return on investment. News about the property market will continue to drag on the market. Beijing wants the property sector to de-gear. They want an orderly property market between individuals and developers through a stable supply.” Exogenous factors still plague the outlook. “Non-market events include actions in the South China Sea and a major reallocation of portfolio assets due to the Russia-Ukraine conflict.” Wang is turning positive towards his China allocation. “Exposure to China has increased after a meaningful reduction in the first half of 2021 because of attractive valuations, less harsh regulation and the easing cycle of China monetary and fiscal policies,” he says. This article originally appeared in the April 2022 edition of Funds Europe. ©2022 funds global asia

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