Asia ex-Japan has persistently underperformed in recent years as developed markets have hit new highs. This year alone, the US has exceeded its 10-year high 28 times, while both Europe and Japan have surpassed this peak on more than 20 respective occasions. Asia ex-Japan still trades below the levels seen three years ago.
This underperformance has led to a prolonged period of outflows and a near decade-low underweight positioning amongst global equity managers. Asia ex-Japan now trades at a 30% discount to global equities on a 12-month forward price-to-earnings (P/E) basis.
Interest in Asia has been extremely low, valuations depressed, and expectations muted. All that is about to change, we believe, for three key reasons.
Changing monetary policy
The change in monetary policy in developed markets, most importantly the US Federal Reserve initiating a generous rate-cutting cycle, is extremely important for the region.
Asia has not faced the inflation problems of developed markets. A number of central banks, particularly in Southeast Asia, have had the ability to cut rates for some time.
But concerns around maintaining currency stability have led many countries, including China, to essentially mirror US monetary policy. As a result, tighter financial conditions have impacted valuation multiples in the region, and in some cases, earnings.
China’s move to cut its reserve requirement ratios and key interest rates within an extensive stimulus package is a clear sign that Asian central banks now feel free to run less restrictive monetary policy, supporting growth and earnings upgrades.
China is unlikely to be able to cut rates as deeply as the US, so we expect the real interest rate differential between the countries to expand in the next year or two. That will put upward pressure on the renminbi, giving China the space to continue to ease monetary conditions.
China’s decision to stimulate was its big ‘do whatever it takes’ moment – a line in the sand. But it is not the end of the process, it is the start.
Structural reform in China
China’s debt deflation problem, caused by overcapacity and weak demand, has been exacerbated by its decision to import US monetary policy. Running high real interest rates has led to weak nominal GDP growth, now in the low single digits. Corporate revenue growth in the second quarter was -1%.
China knows it cannot just pump more debt into the economy to break the deflationary cycle. Recently, the third plenum, Politburo, and State Council meetings have resulted in several promising reforms, including hukou and social welfare reforms alongside possible rural land reforms.
The announced reforms to the hukou (residence permit) represent an important shift. Traditionally, the hukou system has restricted internal migration by allocating social benefits, such as education and healthcare, according to place of birth, meaning households who have migrated to tier-one cities for work have to pay social security in those cities. Granting rural migrants access to public services based on their current residence should reduce the need for saving.
Similarly, the anticipated land reform measures, which could see people granted value for the land they have been utilising, is essentially a transfer of wealth from the state to the private sector, offering China’s large rural population a way to benefit from common prosperity. Urbanisation is likely to increase, and the workforce can expand again.
Importantly, we could see a significant boost to domestic consumption, something that could be meaningful in a country with a household savings rate of more than 30%.
Historically, investing in Chinese equities at the peak of its deflation cycle has led to strong forward returns, 50%-100% over a 12-18-month period.
With China committed to changing its economic model, we are increasingly confident that it will be able to break out of deflation and drive higher domestic demand.
The new tech hardware cycle
Asia is home to a number of companies that have benefited from recent developments in artificial intelligence (AI), including large language models. But the next phase, as we enter the next 12 months, will see innovation, creativity and demand move downstream into products and devices.
Here, Asia has many world-leading assembly and component companies that are likely to benefit disproportionately from the new product upgrade cycle for tech hardware.
This cycle is set to be most pronounced in the PC and smartphone markets, with forecasts suggesting that by the end of 2026, 100% of enterprise PC purchases will be AI-integrated.
The expected release of AI-enabled products beginning next quarter will allow numerous Asian tech companies to capitalise on the burgeoning demand for advanced technology solutions, driving revenue growth, margin expansion, and profitability. This mirrors the growth seen during the mobile internet era, where enablers became the next winners.
Taken together, these three structural growth drivers represent 60%-70% of the Asia ex-Japan market. It is for this reason that we expect earnings upgrades in the region to increase meaningfully from here.
Expectations around Asia have been at near-record lows. No one has wanted to invest there. But today we are the most positive towards the region we have ever been.
Andrew Swan is head of Asia (ex-Japan) equities at Man Group. The views expressed above should not be taken as investment advice.