Even as Covid risks and inflationary pressures loom over Asian economies, stock valuations in some markets have skyrocketed amid a flood of liquidity. Head of Asia ex Japan Equities Elizabeth Soon explains the phenomenon and shares her views on investing in Asia equities in volatile times, why caution is warranted in some areas, and the outlook for 2022.
Asian markets have rallied from their Covid lows despite economies and company balance sheets that remain under significant stress as the pandemic persists and other risks emerge. What accounts for this market euphoria, and is it sustainable?
Despite an extremely challenging period over the past two years, the stock market staged a strong rally. The MSCI Asia Pacific ex Japan Index was up over 20% in 2020 before taking a breather in 2021, notwithstanding the strong performance of small caps. The MSCI Asia Pacific ex Japan Index was flat in 2021, whereas the MSCI Asia Pacific ex Japan Small Cap index was up 18% as of the end of October.1
What’s behind this phenomenon? Low interest rates in the last couple of years have led investors to search for higher yield. This dynamic coincided with Covid-related challenges to traditional business models, such as retail and financial services, which prompted a move into e-commerce and fintech stocks to capitalize on the situation. Investors flocked to pay for the visibility of hope versus the uncertainty of earnings. The result was that over the past two years, share prices of unprofitable companies often rallied over those of profitable ones. Unprofitable companies trading at five times price-to-sales ratios highlighted the euphoria of investors willing to pay for the potential for higher profits well into the future.
Meanwhile, China’s changing regulations on fintech, e-commerce, online gaming, and for-profit education, to name a few, coupled with power shortages, led to a shift in assets from China to India. While China is up just over 22% in two years, India has risen more than 46%.2 India’s small cap index staged a spectacular rally over the past two years, rising over 78%, versus the 45%+ gain for large caps.3 And more of India’s population tapped into the stock market in this period: Around 30 million new stock accounts were opened in the past 18 months, nearly doubling the total number of stock accounts to 73 million by October 2021.4 Valuations of small- and mid-cap companies rose higher than for large caps amid the flood of liquidity, and the current valuations make us very cautious on the India market in general.
What are you looking for in 2022?
Several unprecedented events led to massive challenges in 2021, including Covid resurgences, semiconductor shortages, and freight cost inflation, along with power shortages and regulatory changes in China. We expect some of these issues to abate in the short term, while others, such as the semiconductor shortage, may be more difficult to resolve. The global recovery from Covid, rising inflation, and China’s ability to maneuver a soft landing for its property sector bear close watching.
We remain sanguine that China’s economy will keep growing in 2022 and believe the steps taken to control property lending and implement structural changes will be positive in the long term. At the same time, rising inflationary pressures could take a toll on Asia’s stock market valuations, making stock selection as important as ever to generate long-term alpha potential.
How would you navigate this economic and investment environment?
We believe our philosophy of investing in companies with strong business models remains key to capturing sustainable earnings and avoiding disappointed hopes. Capital preservation for our investors is top of mind. As bottom-up stock selectors, we favor investing in companies that have weathered past crises and continued to deliver earnings and gain market share. For example, while many investors avoided manufacturing companies in the last couple of years, believing that lockdowns would hurt earnings, some companies actually gained market share during this period.
Given the recent changes, what is your outlook for China equities?
Some Chinese companies’ valuations have become attractive in recent months. We see a lot of opportunities to accumulate quality companies at deep discounts, including in the property sector. When investing in China, one’s time horizon is a critical consideration. We are long-term investors, and we’ve held some of the companies in our portfolio since I joined PineBridge 14 years ago. We look for the right business “moats” and allow our favored companies to grow from acorns to oak trees. Some investors see only the short-term risks in China, whereas we look for opportunities resulting from the positive impact of these changes. We believe the recent regulations will lead to a consolidation of industries – and that the winners will be those that are able to capture opportunities from that consolidation over the long term.
Footnotes
1 MSCI as of 29 October 2021. Refers to gross returns in USD.
2 Bloomberg as of 9 November 2021; represented by MSCI China and MSCI India
3 Bloomberg as of 9 November 2021; represented by the MSCI India and MSCI India Small Cap
4 Central Depository Services (India) Limited (CDSL), National Securities Depository Limited (NSDL), and PineBridge Investments as of November 2021.