Macro Research

Time to re-enter Asia? Is Asia ex-Japan back on our radar?

After the strong rally in late 2022, much faith has been restored to Asian equities but is it the right time to relook and enter Asia now?

Colin Low
|
Published on 13 Apr 2023

Time to re-enter Asia? Is Asia ex-Japan back on our radar? | Open a FREE FSM account and manage all your investments conveniently in ONE place

We maintain our cautious view on China, India, and Hong Kong equities. Without an improvement in the outlook for these key markets, it is tough to turn positive on Asia ex-Japan as a region.

Asia ex-Japan equities are no longer cheap and the margin of safety has faded. Valuations have re-rated higher and are trading near the long-term average after the rally. The majority of the sectors are trading at a premium to their respective long-term averages.

We see no signs that the EPS downgrade cycle for Asian equities is U-turning and we expect further EPS cuts from analysts. Weaker earnings and negative operating leverage could exert greater margin pressure down the road.

We expect an upside potential of 22% by end-FY25 We remain neutral on the region and suggest cutting exposure if investors are overweight. We see greater opportunities in picking markets within Asia rather than having a broad-regional exposure.

While 2022 was largely a brutal year for Asian equities, they managed to close out 2022 with a big rally following more than nine months of relentless beatdown. Bolstered by a flurry of positive news from China alongside a resurgence of global risk appetite, Asia ex-Japan equities (as gauged by the MSCI Asia ex-Japan Index) jumped by around 16% from end-October 22, with solid performances across the countries (as of 10 April 2023). However, this rally was rather short-lived as the global risk-on was quickly snuffed out when geopolitical tensions reignited between China and the West while the US banking turmoil spooked investors.

While the late-2022 rally for Asian equities had restored faith in many investors towards the beaten-down Asian stocks, we remain firm in our view of staying cautious on the region. In our view, the challenging outlook for several Asian heavyweights, a fading valuation edge, earnings and margins risks anchor our decision to remain neutral on Asian equities. In this article, we outline these reasons in detail.

Chart 1: Asian equities had a strong rebounded in 4Q22, after a heavy correction throughout the year

1. Staying cautious on the Asian big boys

China: We maintain our negative view on Chinese equities despite an emerging bullish consensus. The region’s equities have rallied on the reopening story and we think a lot of optimism has been priced in. This has opened up doors for a potential correction as negative catalysts are beginning to build. Risks of disappointment in China’s growth data and re-escalation of US-China and China-Taiwan tensions are factors that may hold back Chinese equities.

China’s reopening is ill-timed. The dismantling of its zero-Covid policy comes at a time when the rest of the world is slowing down. As such, China’s exports will likely face headwinds in the year ahead. Consumers will have to come out in full force to spend in order to pick up the slack left behind by its export industry. At this point, it remains unclear if consumption will indeed rebound strongly, as battered consumer confidence, chronically high youth unemployment, and a lacklustre property sector may hold back China’s consumption.

There are also longer-term structural issues that worry us. We expect China to accelerate its shift to a top-down state-controlled economy. As the balance of priorities shifts towards self-sufficiency instead of economic growth, this may result in a low-growth period. The long-term profitability of private companies is also at risk, especially those that are not aligned with the government’s policy direction. China’s foreign policy stance will likely be more assertive, with President Xi steering China away from reconciliation with the West and increasingly adopting a harder line on Taiwan.

India: We downgraded Indian equities last year (October 2022) primarily on grounds of lofty valuations, rising de-rating risks, as well as concerning factors like potential earnings downgrade and an unsustainable macro recovery. Since late December, Indian equities have largely declined in part due to the recent Adani controversy, which soured investor sentiments and stoked fears of a spillover to the financial sector.

Since our downgrade, valuations have declined slightly but Indian equities (gauged by the Sensex Index) are still trading at a wide premium to the long-term average. Indian equities also remain pricey relative to Asian equities, despite the recent rally in North Asian and ASEAN equities. While lofty valuations often imply weaker longer-term returns, it is a bigger deal to us now as India will be entering a global recession with historically high valuations if one were to materialise this year (our base case). These are levels last seen during the global financial crisis and the Covid-19 pandemic, during which a significant de-rating in each episode resulted in large drawdowns.

This is a risk we see at the moment alongside the potential for more earnings downgrades. In addition, we expect muted upside potential of 16% by March 2026 (as of 10 April). Together, these reasons continue to anchor our cautious view on Indian equities. That said, we acknowledge the strong secular growth opportunities in India but are hesitant to pay a big premium for it – at least not when many other emerging market peers are cheaper. Therefore, we are keeping Indian equities on our watch-list and waiting for re-entry once valuations become more palatable and risk subsides.

Besides China and India (Chart 2), we remain cautious on Hong Kong equities for similar reasons to China. Without an improvement in the outlook for these key markets, it is tough to turn positive on Asia ex-Japan as a whole. That said, we continue to hold a positive view on ASEAN, including markets like Singapore and Malaysia, which is partly why we are not outright negative on Asian equities (Table 1). The diverging views within the region is also a reason why we believe greater opportunities lie in picking countries/regions within the region rather than a broad-Asia exposure.

Related articles:

A painful and perilous economic recovery awaits China. Buyers beware.

Is this EM powerhouse cheap to enter after the recent rout?

Is the Adani controversy a cause for concern for your portfolio?

Chart 2: China, HK, and India have an overwhelming presence in MSCI Asia ex-Japan

Table 1: Summarised view on Asian markets we cover

2. Valuations no longer cheap. Margin of safety has faded.

The flurry of positive news from China since late 2022 has not only uplifted Chinese equities, but also supported the broader Asian equity markets, driving valuation multiples higher. As a result, the consensus PE ratio of the MSCI Asia ex-Japan Index has jumped from a low of 11.2X (in late-Oct 22) to 13.7X (as of 10 April), hovering around the long-term average (Chart 3). At the index level, this re-rating was driven largely by the rally in equity prices rather than cuts to earnings estimates, which were largely flat over the period.

At the surface, Asian equity heavyweights like China, India, and Hong Kong – which collectively account for almost 60% of the index – contributed to the higher valuations, while the other markets traded cheaper than historical averages. Looking deeper, the valuation picture looks less rosy across sectors. Six out of the 11 sectors are trading at a premium to their respective long-term averages (Chart 4). Only the financials, consumer discretionary, industrials, and energy sectors are trading at a notable discount. Most sectors saw a jump in valuations, which is obvious when comparing to the PE multiples in November last year before the rally.

We think valuations at the sectoral level show a more meaningful picture that Asia ex-Japan is no longer cheap compared to last year. This suggests that the high margin of safety for Asian equities appears to have faded. With the lack of valuation advantage for Asia ex-Japan, we believe more value opportunities could be found at the country level. Again, this supports our belief that more opportunities lie in picking countries/regions within Asia.

Chart 3: Forward PE ratio for Asian equities have re-rated back to long-term average levels

Chart 4: Most sectors are trading at a premium to their respective long-term averages

3. Earnings cut to continue this year. Margins will be under pressure

Last year, the MSCI Asia ex-Japan Index experienced a -13% downgrade in earnings estimates, with analysts cutting their EPS estimates across all sectors, except energy. This was first led by the tech, consumer discretionary, and communication services sectors. Many of China’s internet companies saw heavy earnings cut under tighter regulations and an ultra-restrictive Covid policy. Semiconductor and hardware companies also faced profit headwinds as a softer global demand and inventory destocking led to shrinking profit margins.

More recently, the baton was passed to cyclical sectors like materials, industrials, financials, and real estate, leading to the next phase of earnings downgrade. A further softening of global demand has fuelled downgrades from these sectors which typically thrive during periods of strong growth. Region-specific factors, such as China’s property sector woes, ultra-strict Covid restrictions in 2022, and late-reopening in several Asian markets, further weighed on earnings of Asian cyclicals.

We see no signs that the EPS downgrade cycle for Asian equities is U-turning and we expect further EPS cuts from analysts, which may present further downside risks for Asian equities. First, we expect higher-for-longer Asian policy rates should continue to weigh on Asian earnings. Second, a further slowdown in global and Asian growth after China’s re-opening support fades will weigh on Asian earnings.

A look back at historical episodes of major earnings downgrade shows that last year’s cut was relatively tame. In 2022, when inflation surged and global growth decelerated, Asian equities saw a -13% cut to earnings estimates. This was less severe compared to previous downgrade cycles that saw an average cut of -21%. In a recession, earnings may see a larger cut within a short period as during the GFC, analysts slashed estimates by 46% in a span of eight months.

Chart 5: Consensus EPS cuts last year considered tame compared to historical episodes of major EPS cuts

Negative operating leverage also signals potential margin pressure moving ahead (Chart 7). This happens when sales growth outpaces earnings growth, often as a result of higher costs. Since 4Q 21, operating expenses for Asian companies have started to climb and have outpaced sales growth. As a result, operating leverage for the MSCI Asia ex-Japan index (captured by the difference between earnings and sales growth) has fallen back to negative territory in 3Q22. This is also reflected on a sectoral level where the 3Q and 4Q earnings results show that EPS growth lagged behind sales growth for most sectors. Based on forecasts, analysts are expecting the negative operating leverage to persist throughout this fiscal year which suggests margin contraction moving ahead.

Net margins have fallen but only marginally from a post-Covid peak of 10.5% (March 2022) to 9.4% (December 2022). In fact, the net margin is still at the 63th percentile, close the median level across history (Chart 6). The same can be said for operating margins as well, which is at the 78th percentile. At current levels, and when compared to prior margin troughs, we believe that margins for have ample room to fall, especially with a challenging earnings outlook and likely further EPS cuts.

Chart 6: Margins are far from the trough. Net and operating margin is still at the 63th and 78th percentile across history.

Chart 7: Operating leverage has turned negative, signalling more pressure on margins. Consensus expects this to last the fiscal year.

Staying neutral on Asia ex-Japan equities

Since our last update, we have revised our earnings estimates for Asian equities. We expect earnings to decline by -3% in FY23, after a -12% decline last fiscal year. With our fair PE and revised EPS estimates for Asia ex-Japan, we project an upside potential of 23% for the region by end-FY25. Looking ahead, we believe the road to recovery remains tough for the region given the challenging outlook for key Asian heavyweights as well as potential downside risks from earnings and margin contraction. Meanwhile, the margin of safety provided by cheap valuations has also faded after the recent re-rating. Coupled with a lacklustre upside potential, we maintain our stance and remain neutral on Asia ex-Japan equities.

As such, we suggest cutting portfolio exposure to Asian equities if investors are overweight or have a heavy position within the portfolio. We see greater opportunities in picking markets/regions within Asia rather than having a broad Asian equity exposure. For investors who want to maintain exposure to Asian equities, we suggest re-allocating to ASEAN, a more resilient region within Asia with comparable correlations to major equity indices. In terms of Asia ex-Japan markets, we prefer South Korea, Taiwan, and Singapore. Beyond Asia ex-Japan, we like Japan, which is our top equity pick. We also continue to retain our preference for LATAM and Brazil.

Chart 8: Earnings forecast and price performance of MSCI Asia ex-Japan Index

Table 2: MSCI Asia ex-Japan upside forecast

Asia (MSCI Asia ex-Japan Index)	FY2022	FY2023	FY2024	FY2025
PE ratio (X)	13.8	14.3	12.5	11.1
Projected earnings growth (YoY %)	-12.1%	-3.3%	18.2%	13.4%
Projected Earnings Per Share (EPS)	44.7	43.3	51.2	58.0
Target fair price (Based on 13.5X Fair PE ratio)	-	-	-	783
Potential upside (%)	-	-	-	23.0%
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 10 Apr 23.

Table 3: Recommended products

Market	Recommended Products
Market	Unit Trust	ETF
ASEAN	Principal ASEAN Dynamic Fund Class SGD	Premia Dow Jones Em ASEAN Titans 100 ETF
Japan	JPMorgan Funds - Japan Equity A (dist) SGD	iShares MSCI Japan ETF
Japan	Eastspring Investments - Japan Dynamic AS SGD	iShares MSCI Japan ETF
Taiwan	-	iShares MSCI Taiwan ETF
South Korea	-	iShares MSCI South Korea ETF
Singapore	Nikko AM Singapore Dividend Equity SGD	SPDR® Straits Times Index ETF
LATAM	Schroder ISF Latin American A Acc SGD	iShares Latin America 40 ETF
Brazil	-	iShares MSCI Brazil ETF

The Research Team is part of iFAST Financial Pte Ltd

Declaration:

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Time to re-enter Asia? Is Asia ex-Japan back on our radar?

Colin Low

Published on 13 Apr 2023

Chart 1: Asian equities had a strong rebounded in 4Q22, after a heavy correction throughout the year

1. Staying cautious on the Asian big boys

Chart 2: China, HK, and India have an overwhelming presence in MSCI Asia ex-Japan

Table 1: Summarised view on Asian markets we cover

2. Valuations no longer cheap. Margin of safety has faded.

Chart 3: Forward PE ratio for Asian equities have re-rated back to long-term average levels

Chart 4: Most sectors are trading at a premium to their respective long-term averages

3. Earnings cut to continue this year. Margins will be under pressure

Chart 5: Consensus EPS cuts last year considered tame compared to historical episodes of major EPS cuts

Chart 6: Margins are far from the trough. Net and operating margin is still at the 63th and 78th percentile across history.

Chart 7: Operating leverage has turned negative, signalling more pressure on margins. Consensus expects this to last the fiscal year.

Staying neutral on Asia ex-Japan equities

Chart 8: Earnings forecast and price performance of MSCI Asia ex-Japan Index

Table 2: MSCI Asia ex-Japan upside forecast

Table 3: Recommended products

The Research Team is part of iFAST Financial Pte Ltd

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Time to re-enter Asia? Is Asia ex-Japan back on our radar?

Colin Low

Published on 13 Apr 2023

Chart 1: Asian equities had a strong rebounded in 4Q22, after a heavy correction throughout the year

1. Staying cautious on the Asian big boys

Chart 2: China, HK, and India have an overwhelming presence in MSCI Asia ex-Japan

Table 1: Summarised view on Asian markets we cover

2. Valuations no longer cheap. Margin of safety has faded.

Chart 3: Forward PE ratio for Asian equities have re-rated back to long-term average levels

Chart 4: Most sectors are trading at a premium to their respective long-term averages

3. Earnings cut to continue this year. Margins will be under pressure

Chart 5: Consensus EPS cuts last year considered tame compared to historical episodes of major EPS cuts

Chart 6: Margins are far from the trough. Net and operating margin is still at the 63th and 78th percentile across history.

Chart 7: Operating leverage has turned negative, signalling more pressure on margins. Consensus expects this to last the fiscal year.

Staying neutral on Asia ex-Japan equities

Chart 8: Earnings forecast and price performance of MSCI Asia ex-Japan Index

Table 2: MSCI Asia ex-Japan upside forecast

Table 3: Recommended products

The Research Team is part of iFAST Financial Pte Ltd

Ways to Invest with FSM Global

Don't have an account with us?

Need Financial Advice?

Latest Articles More

more.articles More

Live Chat 8:30am to 10:30pm, (Mondays to Fridays excluding PH) and 8:30am to 12:30pm, (Saturdays excluding PH)

Select Country/Region

Live Chat
8:30am to 10:30pm, (Mondays to Fridays excluding PH) and
8:30am to 12:30pm, (Saturdays excluding PH)