Asia ex-Japan equities: With better yields and better upside, why keep concentrated holdings in low-risk bonds amid interest rate normalisation?

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This is a sponsored article from Value Partners.



Frank Tsui, Fund Manager, Value Partners.

With a strong earnings per share (EPS) growth outlook, supportive economic indicators and an increasingly attractive relative value versus bonds, Asia ex-Japan equities are not only the strongest they have been in six years but are also a viable alternative for income with promising upside potential.

Stage is set for regional earnings growth
Frank Tsui, Fund Manager at Value Partners, believes the stage is set for global equity markets given a robust EPS growth outlook.

Indeed, analysts have gone so far as upgrading post-earnings EPS projections for Asia ex-Japan equities from +12% to +15% (the first such upgrade since 2010), a clear sign of market-wide optimism, while the Producer Price Index (PPI) is signalling reflation which will have a delayed contribution to positive earnings figures.

“This is very constructive for equity investors,” Tsui says, alluding to headwinds that risk assets have faced in recent years. “We were at an inflection point last year, especially after Trump’s US election victory. After the global financial crisis, investors became used to a low-rate, low-growth environment and have been trying to squeeze whatever returns are left in the fixed income market.”

After resistance from Congress to pass a new healthcare bill, onlookers are even more optimistic that the new US administration will successfully push through either one or both of the two other major campaign promises of tax cuts and increased fiscal spending—both of which if successfully implemented will continue to support the reflationary environment.

Asia ex-Japan equity in spotlight
Within the equity allocation, Tsui is particularly bullish on Asia ex-Japan, not only due to stronger long-term growth prospects, but also the sector’s attractive high yield component – a critical factor for bond-biased investors who pursue yield with vigour.

Currently, companies in the Asia ex-Japan benchmark are registering high cash levels (the cash to market cap ratio is more than 20%) and low net debt to equity ratios (around 20%), while earnings growth prospects remain intact.

Even so, risk-averse investors are questioning just how a strong US dollar will impact equity markets, especially when considering a track record of Asian outflows to the US.

“The question of how an interest rate hike could impact equities is more complex than people think,” Value Partners’ Tsui explains. “Yes, historically, dollar strength is negatively correlated with Asia ex-Japan equities, but we have to dig deeper down to really see the cost of interest rate pick up on the US dollar.”

First, fundamentals in Asia today are better-placed to withstand dollar strengthening and regional economies and their current accounts are capable of absorbing the effects of dollar strengthening.

Second, the US Federal Reserve (the Fed) is increasing rates, not because of high inflation, but because growth recovery is underway. Absent inflationary pressures, the Fed is unlikely to hike too aggressively and moderate rate normalisation tends to have a positive effect on Asia ex-Japan equities.

Global investors are already moving to reallocate, showing no fear during this rate hike cycle. After the Fed Chairman Janet Yellen hiked rates in March for the third time during her term, more than US$8 billion flowed into Asia ex-Japan equity markets, propelled by momentum and fundamentals. Tsui adds that the Shanghai market slump in 2015 was punishing and that it historically takes up to a couple of years for sentiments to recover when markets plunge 30-40%, but the tide may have turned.

Asia equity dividends: Better yields than bonds, better upside than market beta
“Yield-seeking will remain as the mainstream behavioural trait amongst investors,” Tsui reiterates, illustrating the potential of Asia ex-Japan equities as an alternative income source in addition to the sector’s strong capital appreciation potential.

With relatively high cash levels and low debt obligations, shareholders of companies from the region are well-positioned to receive an increasing level of dividends. Moreover, dividend yields are already at elevated levels relative to fixed income markets. Currently, the MSCI Asia Pacific ex-Japan High Dividend Yield Index is yielding ~5% while the JP Morgan Asia Credit Composite Index (JACI) is yielding ~4.5%, as of 20 March 2017. Meanwhile, rising interest rates could place further pressure on fixed income proxies like investment grade bonds.

The regional high yield equity benchmark’s resilience is noteworthy, especially for those contending that investors could instead adopt a full risk-on approach in a reflationary environment. On top of closely tracking the broader Asia ex-Japan benchmark, the MSCI Asia ex-Japan High Dividend Yield Index outperformed the MSCI Asia ex Japan Index during the last cycle when net debt ratios were higher and cash levels were lower. Interestingly, dividends constitute two-thirds of the total returns of the MSCI Asia Pacific ex-Japan Index over the past decade.

Despite the market’s strength, it is imprudent to simply buy the whole index, with the relative value of its constituents demanding bottom-up capabilities. This is due in part to the benchmark’s high exposure to the financial sector regionally. Value Partners believes that the bottom-up approach offers greater flexibility for fund managers to pick companies which are able to generate better earnings and produce more consistent free cash flow.

On a regional basis, Tsui is overweight on North Asia and, in particular, Greater China and South Korea, while on a sectoral basis, he is bullish on real estate, industrials, consumer discretionary and IT hardware.

With an environment conducive to capital appreciation, backed by outperforming dividend yields driven by healthy cash flow positions, Tsui’s advocacy for the market is based on a simple yet fundamental premise: “Why invest in a low-risk bond instrument (paying 4.5% yield with increasing duration risk) when you can invest in sound dividend-paying equities (with a 5% yield and potential for appreciation)?”


The views expressed are the views of Value Partners Limited only and are subject to change based on market and other conditions. The information provided does not constitute investment
advice and it should not be relied on as such. Information in this material has been obtained from sources believed to be reliable as of the date of presentation, but its accuracy is not guaranteed. This material contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

This is a sponsored article from Value Partners.

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