A Return to Rationality – the Outlook for Asia ex Japan

The investment backdrop throughout 2022 has, thus far, been sub-optimal for investors.

Myriad macroeconomic events have created a hostile environment for equities. Inflation crept into the system last year as the global economy emerged from COVID-19. The pandemic and subsequent lockdowns put pressure on the global supply chain which naturally had an impact on prices.

This situation was exacerbated in February when Russia launched its invasion of Ukraine. Both nations are large exporters of agricultural goods and commodities, with much of the world’s oil and gas supply stemming from Moscow. Inflation, as a result, has surged across the world, with central banks in the U.S., U.K. and Europe forced into monetary tightening cycles.

In Asia, many economies have been slower in re-opening and have continued to enforce restrictions designed to stem the pandemic. This has been especially the case in China, where the nation’s zero-COVID policy has seen entire cities placed into lockdown and thereby ground factory productivity to a halt.

While inflation has been less prolific in Asia, it has trended upwards throughout the year and central banks in the region have proactively raised interest rates as a result. China has been an outlier in this regard, embarking on a modest quantitative easing policy as it has sought to reinvigorate its economy.

So, having endured a challenging first half of the year, what can investors expect from the Asia ex-Japan market going forward?

A return to rationality, led by China

As the fulcrum of the Asia ex-Japan index, China’s performance has a significant impact on the region’s investment profile.

China’s zero-COVID policy has been detrimental to the nation’s economic recovery despite some largely supportive monetary and fiscal policy responses from the government. In our view, the pent-up economic stress created by this policy should give way to an easing of pandemic-related restrictions and a reversion to a more pragmatic approach to infection control.

We believe it is a case of ‘when’ not ‘if’ China relaxes its COVID protocol and we are likely to learn more in October when Beijing hosts the 20th Congress Party of the Chinese Communist party. In the weeks preceding, COVID-related restrictions will likely tighten in order to protect the event but we expect these will ease in the aftermath. President Xi Jinping’s recent visits to Kazakhstan and Uzbekistan marked his first overseas trip since the pandemic began. This, paired with an increase in long-haul flights coming into China, may foreshadow a relaxation in the country’s protocols on COVID.

From an international perspective, China’s relationship with the U.S. remains a topic of concern for investors, particularly as it pertains to Taiwan. Although tensions remain, we believe that military conflict between China and Taiwan is a low-probability event. That being said, we do foresee a continued decoupling of economic activities between the U.S. and China as a result of the tension, particularly around technology.

This dynamic may open several interesting angles for investors. For China, technology, energy and food independence will become increasingly important, which may present some interesting investment opportunities at a domestic level. Any sign of the U.S. diversifying its supply chain away from China may also be positive for emerging economies, such as Vietnam, Indonesia and India, which are each well placed to fill the void.

With this in mind, we remain optimistic about the outlook for these economies, particularly Vietnam, where several positive structural tailwinds are currently in play.

On-the-ground research visits have resumed

Across Asia, travel routes are beginning to re-open, which should be positive both from a domestic and global economic perspective. For us, as active investors, we have been pleased to embark on several research trips across the region.

We believe our in-depth, on-the-ground fundamental research helps us to identify and vet the most compelling opportunities. In recent months, our team has visited both Thailand and Vietnam – two of the key emerging economies within the region.

These trips are invaluable for a variety of reasons as having ‘feet on the ground’ allows for a better understanding of each market’s position in the economic cycle. For example, on our trips this year, we assessed the ‘reopening’ of the Thai and Vietnamese economies.

In Thailand, we were able to observe first-hand how government and corporates alike were working to restore the economy to pre-COVID conditions, ahead of welcoming international tourists back to the country. As portfolio managers, this experience offers us greater colour on the Thai re-opening trade, for example, regarding hotels, restaurants and medical tourism stocks, which on the whole have reacted positively to the country’s move towards normality.

From a bottom-up perspective, international travel allows us to take a more granular approach to stock selection, affording the opportunity to ‘kick the tyres’ of companies beyond balance sheets and corporate appraisals alone. This is perhaps most relevant in the case of pre-IPO companies, where face-to-face conversations can add significant value.

Volatility presents opportunities

While we anticipate a continuation of market volatility in the near term, we are excited by the opportunities developing throughout Asia.  

Despite the headwinds witnessed through much of 2022, Asia’s multi-year structural growth story continues to unfold, particularly in emerging economies such as Vietnam.

Much will hinge on China, as the dominant constituent of the index, but there are reasons to be optimistic. The adoption of a more pragmatic approach to managing the pandemic, dovetailed with a more supportive environment for economic growth, will go far in reversing negative sentiment towards Chinese equities, particularly while valuations are suppressed.

The opening of borders has enabled our team to collect detailed data through on-site visits, and in our view a broader economic reopening in the region could benefit companies in some of the smaller markets in Asia.  

We remain constructive on the outlook for Asian equities but acknowledge that in the current risk-off environment selectivity remains key. Volatility in markets can be challenging but it can also present exceptional opportunities for those with dry powder to deploy and a long investment horizon.  In our view, Asia equities today provide intriguing opportunities for investors.

Yu Zhang
Portfolio Manager
Matthews Asia