Dear Valued Investors,
The first quarter of 2018 saw the return of volatility to the stock market. True volatility! Not just a euphemism for a bear market. The strong start to the year was quickly turned on its head as Asia's markets peaked in late January and had a very weak first few days of February. The rest of the quarter seemed to usher in an unstable recovery, until again at the end of the quarter, markets fell under fears of trade wars and concerns over the narrowness of the market rally.
For it is true that throughout much of the volatility of the quarter, the leadership of the market never really changed. Throughout 2017, it had been the mega-cap growth names (emblemized by the Chinese internet companies) that had done better in the rally, protected better during the fall, and recovered most ground during the recovery. For those seeking protection in value stocks or stable bond proxies, there was precious little safety to be had. And thus, whilst the gyrations of the stock market added a degree of nervousness for investors, it didn't seem to augur any change in the underlying characteristics of the market.
Until the end of the quarter that is.
There had been some indications that earnings growth in China in particular had been broadening out beyond just a few industries. This would normally presage performance broadening out, too, as the premium previously paid for the few growth areas of the market starts to dissipate and investors look to companies for better value. We would also anticipate small- and mid-cap companies to benefit from such a trend. Indeed, this is broadly the pattern we have seen in Japan over the past few years: reflation causes a market led by financials, ETF flows push up large caps. Later on, however, it is the small- and mid-cap companies that take up the running.
The first real cracks seemed to appear in the S&P 500 Index toward the end of the quarter, too. The recovery from the acute falls in late January and early February had been greeted with some relief. But it soon petered out under the weight of weak earnings and rising U.S. Federal Reserve policy rates (the Fed hiked rates again on March 21). All this was exacerbated by valuations that have been far from cheap. Has the U.S. rally finally come to an end? It is too early to say but I would not be surprised if U.S. equity returns are much weaker going forward than they have been over the past few years. This seems an obvious statement, but the emotion of momentum in markets can often prevent people from seeing clearly what is right in front of them.
And as the U.S. market fell, Asian markets dutifully followed suit. It would be wishful thinking to expect them to buck the U.S. market trend in the short term, surely. But there are a few things to say in favor of Asia's equity markets.
First, as the financial press has reported, Asia's central banks did not immediately follow the Federal Reserve Bank's rate hike. Either they did nothing, or, as in the case of China, followed with a meager rise in rates of a few basis points. Why is this? Well, economies in Asia are not obviously as late cycle as we are in the U.S. (I would argue that even the U.S. need not raise rates) but when you look at high current account surpluses and low core rates of inflation in Asia, surely there is still room for economic stimulus, be it fiscal or monetary. Those same fundamentals suggest that Asia's economies ought to be able to stimulate without causing large swings in their currencies—it's a bit of a sweet spot for policymakers.
Second, earnings in Asia have been accelerating, even as they have been tailing off in the U.S. One big factor behind this was the willingness for Asia's governments to squeeze corporate profits in the years after the Global Financial Crisis, to ensure that the worker got a fair deal and indeed, more than their usual share of economic growth. This is in stark contrast to the political economy of the U.S., where the capitalist has been on top. So, the U.S. lemon has been squeezed until the seeds have shot out, whereas in Asia, there may be plenty of juice left.
And finally, this has been happening in an environment in which Asia enjoys a reasonable valuation advantage over the U.S. At the time of writing, the FactSet Aggregates 12-month forward price-to-earnings ratio for the U.S. is 17.4X; for Asia ex Japan it is 14.0X; for Japan 13.9X. Europe is similarly priced to Asia. But it is surely in Asia that the cycles, both the profit cycle and the policy cycle, are most conducive to equities. And so, will this correction continue? Where does it end? Impossible to know, but I am confident at least, given the starting point of valuations and the relative stage of the cycles we have discussed, that value will emerge far more readily and quickly in Asia than elsewhere in the world.
On top of this, a recent visit to New York cemented me in the opinion that sentiment toward Asia appears to have become significantly more positive than has tended to be the case for the past few years. This sentiment could be hurt by the looming trade war. But, in my opinion, given that U.S. unemployment is so low, there is very little to be gained from tariffs at this point. What jobs may be won in the steel industry (and there are surely very few) will be likely more than offset by job losses elsewhere as higher costs are absorbed. There is only so long you can keep shooting yourself in the foot before it starts to hurt. I don't think China will ignore the tariffs but we have long suggested that any response will be minimal. China has its eyes on the long run—putting itself at the center of global trade by building land sea and air routes to all four points of the compass. As the U.S. retreats, China steps forward.
For our portfolios, all of this is mixed news. For as much as the absolute returns are likely to suffer during a period of weak markets, we have always tried to bias ourselves to the smaller and medium-sized companies that serve domestic demand in Asia. Perhaps this may help us weather the new volatility; I am confident that, as we look further out, it is the right place for our portfolios to be focused. For, whosoever sits at the center of global trade has usually reaped the benefits of a vibrant economy and society.
Robert Horrocks, PhD
Chief Investment Officer
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