Neil Dwane summarizes our recent AllianzGI Asia Conference in Berlin: Increased intra-regional trade, reform-minded leaders and positive demographic trends help Asia provide the growth and income potential that today’s investors need.
Our clients and investment professionals recently met in Berlin for our annual AllianzGI Asia Conference. Here are some of the highlights from two days of discussions and events, which provided our guests with a host of investment insights about the world's most dynamic region.
If the globalization tide turns, Asia can swim against it
Asia has long been a beneficiary and a driver of globalization – a force that has increased prosperity and opportunity around the world. In fact, after decades of globalization, the gross domestic product (GDP) of Asia (excluding Japan) is twice the size of Europe's when adjusted for purchasing power parity. And by 2020, Asia (ex-Japan) should provide 40 per cent of the world's GDP.
Yet even if the political tide in the West turns against globalization and toward populism, Asia is well-positioned to swim against it. The growth of intra-regional trade within Asia should make America's growing protectionism less menacing, at least economically. Moreover, China's "One Belt, One Road" initiative should, over time, boost economic development throughout the region and across its frontiers. This should increase the size of many markets in Asia, which would give corporations an abundance of choice about where to invest their resources.
Reforms are changing how investors look at China
Over the years, investors interested in Asia's growth potential have rightly focused on China, which has been transitioning from an economy focused on manufacturing and exports to an economy focused on services and consumption. China has a currently manageable overall debt burden, but its rate of growth will inevitably start to slow. Nevertheless, Beijing possesses the tools needed to manage growth – chief among them the ability to manage leverage inside its banks and state-owned enterprises.
For their part, China's savers have developed a reputation for being very short term and aggressive in the demands they place on China's banks. Yet there are new signs that – at least outside the property markets – the Chinese are looking to save for their health care and welfare in a more structured, sustainable fashion. Moreover, outside of China itself, Asia has a strong Chinese diaspora that is keen to invest in China's prosperity, even if other international investors are awaiting the enactment of additional legal, regulatory and political reforms.
Reform will certainly be on the agenda at China's Communist Party congress in November: Prime Minister Xi Jinping has kept up his reform efforts and projected stability as he prepares to present his Five Year Plan.
Elsewhere in the region, South Korea seems to be getting closer to making significant reforms to its chaebols – the Korean term for large conglomerates – to release innovative talent and excess capital for reinvestment.
Asia is experiencing significant demographic shifts
South Korea and China are, like the West, suffering from the greying of their populations. And despite increasing levels of household earnings around the region, there is still a risk that many Asians will neither save enough nor have enough children to survive without government assistance.
At the same time, there is an important mega-trend taking shape across the region: the emergence of the Asian middle class. While the global middle class has already grown at an extremely rapid pace, Asia is set to account for even more explosive growth in the coming years. This represents extraordinary potential spending power over the coming decades.
Asia's overall population is also young, increasingly well-educated, technology-enabled and hard-working – and the median age is only 30 in Asia versus 42 for Europe. The Philippines, India and Indonesia, in particular, have young and growing populations. Overall, this puts the region in a strong position, demographically speaking, compared with the US, Japan and Europe.
India's prospects look increasingly bright
The ongoing attention many investors are paying to China may, in part, be obscuring the progress now underway in India and Indonesia. For its part, India has started to re-awaken as several of Prime Minister Narendra Modi's policies become increasingly popular:
- Demonetization is shining much-needed light into the "black economy".
- The new general sales tax should enhance government and state finances, boosting capital expenditures and reinvestment.
- Aadhaar – a powerful biometrics-based identification system – should reduce corruption, ease unemployment and improve the distribution of subsidies.
All told, India could be inching closer to establishing a virtuous circle of progress, where better tax transparency leads to stronger government finances. This would lead to improved employment, and then to bigger markets. Next could come larger profit pools and better returns to equity investors, and so on. Either way, Indian companies have tended to focus more on profits and returns than their Chinese counterparts, which have generally focused on increasing market share. As such, investors in Indian equities should be rewarded by the improved growth and clearer political policies of the Prime Minister Modi era.
Disruptive forces are changing corporate behavior
While the big US tech companies – such as the FANGs (Facebook, Amazon, Netflix and Google) – have held sway in other markets, they may not be able to fully capitalize on the true potential that Asia offers. That's because their brands and culture may not be sufficiently local to appeal to Asia's millennials.
Instead, a growing number of Asian high-tech firms – including China's BATs (Baidu, Alibaba and Tencent) – are well-positioned to meet the needs of nearly 4 billion consumers in Asia. In fact, it is entirely possible that these names could become larger than their US counterparts, thanks to their ability to stay "plugged in" to what regional consumers want. It is also interesting to note that Europe has not produced any of today's big-name, disruptive tech leaders.
Throughout Asia, as in most of the rest of the world, a greater emphasis is also being placed on environmental, social and governance (ESG) issues, which can have a positive impact on shareholder value and returns. This trend should create attractive long-term returns for global investors, who are seeing ESG-related issues gain traction among corporate management teams, core shareholders and outside interests.
- Good valuations, still-positive real interest rates and low sovereign leverage help Asia offer sound growth potential and market returns.
- China's “One Belt, One Road” initiative should boost foreign direct investment, while trade agreements such as the Regional Comprehensive Economic Partnership could provide additional support for intra-regional trade.
- Thanks to their knowledge of the region, Asia's BATs could become even larger than the United States' FANGs.
- Tension with North Korea could boost regional volatility in the shorter term, particularly if China brings insufficient pressure to bear and the US fails to reduce regional hostilities.
- In the global hunt for income, many shorter-duration, higher-yielding issues in Asia look compelling (denominated both in US dollars and local currencies).
- Investors should monitor the pace of structural reforms, particularly in China and India: They provide investors with strong signals about the potential for future returns.
The "United States of Europe" (USE) has been a work in progress since the end of World War II. Now, with fallout from the financial crisis abating and political risk subsiding, Neil Dwane says Europe is offering compelling investment opportunities.
Although its path toward the USE was not always clear, Europe made impressive progress by the end of the 20th century – including forming the European Union and launching its common currency, the euro. Yet within the last decade, the European project was almost derailed by the global financial crisis and subsequent euro-zone crisis.
Fortunately, the European Central Bank was able to step in and keep the EU's economy ticking. And it worked: Today, worries over austerity, political uncertainty and low confidence are beginning to improve, and the USE could be in sight once again. This has a host of positive implications for European equities.
Five reasons to consider European equities
1. Attractive valuations compared with other equities globally
Europe's GDP and population are larger than the United States’, and many European corporations generate their profits outside Europe. So why should so many European corporations – particularly those in the financial, utility and telecommunications sectors – trade at large discounts to their US competitors? The Case-Shiller P/E of US companies was almost 30x in April; at slightly over 18x, Europe's was significantly lower. With European equities deeply out of fashion, investors have a contrarian opportunity.
2. Low or no bond yields leave little "safe return" regionally
The ECB has been extremely effective in using its monetary and bond-buying policies to lower the cost of credit below zero. This has forced other central banks in Europe – including Denmark and Switzerland – to implement negative rates of their own. As a result, European investors may soon be forced to make a "great rotation" from bonds to equities simply because there are few positive returns available from European bonds. If and when this happens, it will be all the more remarkable because Europe has traditionally had less of an equity-oriented investment culture than the US, the UK and Asia. Fortunately, European equities and alternatives – such as infrastructure debt – provide attractive-yielding alternatives, which could make the switch easier.
3. European economies are finally recovering
As the EU battled with austerity and a broken banking system in recent years, it struggled to find any domestic growth aside from Germany's well-tuned export machine. As a result, the EU's nominal GDP growth (which does not factor in inflation) was stuck in the 1-2% range. Today, however, Europe is enjoying a positive spiral of rising consumption, improving investment and falling unemployment, and nominal GDP growth for the EU is now around 3%. Though the EU still has issues – including Italy's upcoming elections and negotiations over Brexit – it has lower levels of leverage, better savings and a greater ability to increase consumption than the over-leveraged US.
4. Corporate earnings are rebounding after six years of decline
Compared with their US counterparts, corporate management teams in Europe are generally more focused on the long term. Broadly speaking, European balance sheets are also less leveraged, and corporate leaders are generally determined to make investments that improve innovation and productivity. This puts European corporations in a good position to harvest the benefits of their longer-term corporate strategies. As a result, we believe European equities could deliver annual returns in the 8-10% range in the coming years – and we estimate that nearly 50% of this could come from dividend income, which tends to be less volatile.
Among European equities, defense sector stocks are worth watching. In the wake of President Donald Trump's recent comments about NATO spending, European Commission President Jean-Claude Juncker reiterated the need for countries to stand on their own two feet when it comes to defense. This may translate into increased defense spending across the EU.
5. Europe's currencies are cheap and attractive
The US dollar has been a safe haven for many of the world's investors, but its zenith may be in sight. Despite Brexit, the euro and sterling seem quite undervalued. We expect global investors to spend “expensive” US dollars to acquire more attractive, higher-yielding and better-invested assets in Europe – as evidenced by several waves of merger and acquisition activity with European companies.
Watch for continued political challenges
As we move through 2017, it appears that the populist shock wave started by Brexit and the election of US President Donald Trump may be fading. Yet Europe is not out of the woods by any means:
- The UK election result is a reminder that the political landscape continues to throw up surprises. Brexit is far from over, and the direction and likely outcome of those negotiations is difficult to discern.
- Italy still has the capacity to shake the EU and shock the euro. In the run-up to elections next spring, Italy is facing continued political stagnation and an inability to pass much-needed reforms. The risk of a strong anti-Europe result is real.
However, the election of President Emmanuel Macron in France – not to mention his party's new parliamentary majority – and the likely reaffirmation of Chancellor Angela Merkel in Germany should lead to a constructive partnership between France and Germany. A strong "Merkron" alliance could put Europe back on a path toward achieving the job started in 1950s: a truly United States of Europe.