Asset allocation – A global view

With the first quarter of the year witnessing volatility across global markets, The Trade Asia asks managers in the region their outlook for the coming months…

Equities – Australia

By Brad Potter, Nikko Asset Management

The Australian economy looks pristine compared to the commodity peers of Canada, South Africa and Brazil who are either in, or teetering on, recession.

The outperformance seems to be due to the weaker Australian dollar (AUD), benign fiscal policy and low inflation – allowing the Reserve Bank of Australia (RBA) to ease interest rates.

Strong performance from non-resource export sectors, especially tourism, education and agriculture has also helped our economy.

Household spending growth is being supported by solid employment growth, low interest rates and the oil price dividend.

Wages growth is a problem child currently. Nevertheless, selective consumer discretionary stocks should see reasonable support in this environment.

Consensus earnings per share (EPS) growth is suggesting a mid-single digit decline in 2016. However, this aggregate number hides the detail, with resources expected to fall by nearly 46%, while banks and industrials are both expected to grow by around 5%.

Many companies continue to see subdued top-line revenue growth, but the ongoing cost-out programs, together with a disciplined approach around capital expenditure, working capital and the balance sheet should help the bottom line. Companies exposed to the growing middle class in China and Asia are doing well.

Banks are beginning to look interesting post the substantial capital raisings in 2015, however our view (and recently confirmed again by the Australian Prudential Regulation Authority) is that the Australian banks still need substantially more capital. This increased capital has a significant dilutionary impact on return on equity, EPS, dividends per share and ultimately valuations. We have reduced our underweight position in banks.

In resources, we expect the iron ore price to remain weak in 2016. Until we see substantial cuts in iron ore production, it is difficult to see the market rebalancing. Typical supply-side collapses in iron ore last a lot longer than the boom.

Globally, iron ore producers have reduced costs substantially, which has delayed cuts in production. We see no value in the companies within this sector currently.

The oil price is almost universally viewed as a leading indicator of weak economic growth and therefore even weaker demand. However, history has shown that it is actually a presage in activity. The sharp falls in oil prices have been disruptive, but a low price once it stabilises, should be positive for economic growth.

Australia is still a net importer of energy. Unfortunately, the gas dividend expected when all the new LNG projects are operational will not be as great as expected. Value is starting to emerge in a number of energy names on the assumption that long-term prices are higher than today – which we concur with.

The earnings downgrade season has been fairly evident since AGM season from mid-November 2015 through to now. Commodity price downgrades (both spot and forecast prices) have been a big contributor to the downgrades. This has resulted in a revision to FY16 EPS growth from -2% to -6% and we expect further reductions over the upcoming reporting season. Resource companies (and companies that have exposure to resource companies) are likely to have disappointing results and outlook statements.

Equities – China

By Andrew Swan, BlackRock

For eight days in a row starting in December 2015, the People’s Bank of China (PBoC) weakened the yuan reference rate, culminating in a 0.5% devaluation of the currency on 7 January and triggering market sell-offs around the world.

The magnitude of the 0.5% move may look small in absolute terms but it is, in fact, quite significant – it’s the largest one-day move since the sudden devaluation on 11 August 2015, according to Bloomberg.

In response, the China onshore equity market plunged 7% after the first 30 minutes of trading, halting stock trading for the second time in the first four days since a new ‘circuit breaker’ mechanism had been put into effect.

Chinese regulators have since announced a suspension of the circuit breaker mechanism for an indefinite period of time to allow for further study and improvements (see ‘Short Circuit’, earlier in this issue).

Currency impact

We maintain our view that moderate depreciation of the Renminbi against the US Dollar will be likely in 2016, but we expect to see broad stability of the Renminbi against a trade-weighted basket of currencies.

We think that the current weakening may be a pre-emptive move to prepare for currency impact related to further Fed rate hikes to come, but view the timing right after the recent A-share weakness as being somewhat unfortunate.

Market sentiment has soured dramatically towards the A-share market, even though the CSRC looks like it will be proactive in seeking to stabilise sentiment. Along with the rest of the market, we were somewhat surprised that the circuit breaker was triggered twice in the first four days of being operational – the thresholds of 5% and 7% were probably set too tight for the A-share market given its historical volatility level. As a reference, the US circuit breaker thresholds are set at 7, 13, and 20% while Korea’s are set at 8, 15, and 20%. Some adjustments are required ahead of it being reinstated.

In the offshore equity market, we feel that the pessimism is well-priced in in the Hong Kong listed stocks.

Higher volatility is expected in the near term, but with better structural improvements already put in place over the last couple of years (and further improvements may be on the way), we believe that if Chinese regulators successfully achieve a soft landing, we may see a better environment for H-shares than we have had over the past five years.

Portfolio adjustments

We remain constructive on H-shares where we see better relative value. We prefer accessing Chinese stocks via the offshore markets and only have very limited exposure to the A-share market (less than 0.6% in any of our funds).

We stay focused on selecting stock specific exposure in both new and old economy stocks that can benefit from China’s structural reforms, but are cautious on adding exposure in what is a very volatile market.

Equities – Japan

By Hiroki Tsujimura, Nikko Asset Management

Corporate earnings growth in Japan is clearly on a different path than in other regions.

A 15-year deflationary environment has forced many publicly listed companies to dramatically overhaul their cost and revenue structures.

Currently, about 60% of major listed company revenues are estimated to come from overseas.

Thanks to the massive quantitative and qualitative easing programme introduced by the Bank of Japan, we expect a weaker yen will accelerate corporate earnings growth.

It is necessary to consider, however, how solid the growth in earnings per share (EPS) will be. There are two points worth emphasising:

Macro v micro

The macroeconomic environment does not necessarily determine listed company profits. In 2014, listed companies’ earnings reached an all-time high, despite an economic recession. This was the first time that corporate earnings had ever grown in a recessionary environment. We think that it is the start of a trend that will continue.

In our view, if the trend of a strong US dollar and low oil price continues, the Japanese equity market will enjoy a significant competitive advantage over its global peers.

This is due to two main factors: (1) major Japanese listed companies rely heavily on exports and revenues from overseas; and (2) oil and natural gas (of which almost 100% are imported) have become Japan’s core energy source due to the suspension of its nuclear power plants.

Attractive valuations?

The current 12-month forward price/earnings ratio (P/E) for Japan equities is around 14x which is significantly lower than the historical average.

In general, equity market performance can be explained by earnings growth and the expansion of P/E multiples.

However, close examination of the recent performance of Japanese equities reveals an interesting phenomenon: the ‘Abenomics’ equity rally over the past three years can be explained solely by earnings growth, with no contribution from the expansion of P/E multiples.

This is in stark contrast to US and European equity markets, where P/E multiples expanded by more than 20%.

In the case of US equities, one of the reasons for EPS growth and P/E expansion over the last five years was a massive amount of share buybacks. This offers us some insight into the future direction of the Japanese equity market given the recent introduction of Japan’s Corporate Governance Code.

Japanese listed companies’ capital efficiency is still very low compared with their global peers. About one-third of listed companies have return on equity of less than 5%, while about half of them have ROE of less than 8%.

In addition, the average ROE of Japanese firms continues to deteriorate as their shareholder return ratio (sum of dividends and share buybacks as a percentage of net income) remains around 40%, despite corporate earnings reaching an all-time high.

This is partially explained by listed companies continuing to hold high levels of cash, which recently exceeded their hitherto historical high of JPY 100 trillion.

Better governance

The much-awaited Corporate Governance Code finally came into effect on 1 June 2015 and all listed companies were required to either comply with the code or explain their reasons for not complying by the end of 2015.

The code encourages companies to draft and disclose mid-term business plans. This is expected to result in improved ROE as many companies would have to incorporate ROE targets into their mid-term plans.

Therefore, we can expect to see a substantial increase in corporate actions. In particular, we think that there will be increased momentum for share buybacks and dividend hikes in 2016.

In fact, we have recently seen signs of change with regard to corporate actions. In September 2015, the Japanese equity market declined 8% as foreign investors sold approximately USD 20 billion in Japan equities — the largest amount in any given month since the Tokyo Stock Exchange (TSE) started gathering such data. At the same time, Japanese domestic investors, both retail and institutional, bought a significant quantity of Japan equities. This was particularly true of corporations, which engaged in about USD 6.4 billion in share buybacks, also the largest amount since the TSE started gathering such data.