Invesco Perpetual fund managers Stuart Parks, Paul Chesson and Dean Newman give their views on Far Eastern and Emerging Markets, including: the importance and strength of links between China and Brazil; the likelihood of China decoupling from America in the future, and China reaching 8% GDP growth this year; and whether Brazil can still be classified as an emerging market…
Trade flows within the region and the influence of China. What do those factors look like now?
SP: We are having a good recovery from the very poor numbers that we saw in the early part of 2009. Also, on a month-by-month basis, trade flows into China are improving quite considerably. I think this is a trend that will continue as forward-order books still look quite strong, both within Asia, but also to developed markets. So the picture at the moment is quite encouraging.
How are China and Japan going to work together and what will be the impact of Chinese companies competing in the areas where Japan has traditionally been strong?
PC: On the first point, I think the answer is: very well. Japan is benefiting enormously from the growth in China, particularly in areas like the car industry. Joint ventures have allowed Japanese companies to enjoy high levels of growth in car sales in the Chinese market and Chinese companies have tapped into Japanese expertise in car manufacturing. On the second question, I think Japanese brand names are well known globally and they have been dealing with tough competition for a long time. The fact that they now have competition from China is not a new phenomenon for Japanese manufacturers. The key for us, as fund managers, is to continue to focus on the companies that can win that competitive battle.
How strong is the link between Brazil and China and how dependent is Brazil on China’s imports? Also, can you be bearish on commodities yet bullish on emerging markets?
DN: The economic link between Brazil and China is important, and I think it will become more important. Currently, over 25% of Brazil’s primary exports go to China and that number is increasing. China is also Brazil’s largest trade partner; having overtaken the US. My belief is that Brazil has the agricultural produce and mineral resources that China needs and China has the financial fire-power to help Brazil improve its infrastructure and undertake some big mineral projects.
On the second question, commodity prices are important for some emerging markets, particularly Russia and Brazil. But for economies, like Egypt and Turkey, lower commodity prices are actually a good thing. So although what happens with commodities is important, I believe domestic economic growth will be the long-term driver.
Can China decouple from America and how significant is the shift from export-led to domestically-led growth?
SP: We have always said decoupling in economic terms is a 20-year process, which began after the Asian crisis in the late-1990s. While complete economic decoupling is highly unlikely, China is always going to be a substantial provider of manufactured goods for the western world, including America. However, over time, we will see the domestic economy becoming more important to Chinese GDP. In equity market terms, 2008 saw the whole world fall together and risky assets, including China, performed no better than anywhere else. So, in the short-term, stock markets are going to remain highly correlated, but over the long-term, hopefully, that can diminish. With regard to the importance of domestic growth within China as a whole, the authorities plainly believe it is necessary in order to push the economy forwards. It will also help to solve, in time, some of the global imbalances that we continue to struggle with.
Should Brazil still be seen as an emerging market?
DN: For me, Brazil is still an emerging market, and there is still plenty more to go for. Looking ahead, I think there are two key factors. Firstly, up until now, the focus of economic growth has been on the two big cities; Rio de Janeiro and Sao Paolo. More recently, we have seen some very strong growth, in fact stronger growth than elsewhere in Brazil, in the north-east, the centre-west, around the capital, Brasilia, and in the south, where you have engineering and agriculture. I think that could be a big theme, and I will visit some of these places on my next trip to Brazil.
The second issue is the exit strategy. When I use that phrase, I am talking about how Brazil will execute monetary policy as interest rates rise. If it is done in an orderly manner and consolidates the gains they have made on lower interest rates and lower inflation, that will be positive for the investment climate.
The weakening Yen plays into the hands of Japanese exporters and Japan has shown some out-performance. Can this be sustained and are you hedging the Yen?
PC: The question suggests a correlation between the performance of the currency and the performance of the stock market, relative to other stock markets. Whenever I look into this issue there is not much meaningful correlation. In 2005, the Yen was weak and Japan outperformed, but thereafter, the Yen remained weak for the next 18 months and yet the market underperformed. In terms of whether this is going to be different somehow, I assume the question is whether or not the Japanese economy is still prone to boom and bust and I think it is. Given the levels of debt and the ageing population it is an economy that is driven by the external environment and today’s economic outlook is not so different from the past. However, from a stock market point of view, what is different is that stocks are now valued for just such expectations.
So, I think the cycle of ever-lower lows in the stock market through the economic cycles has been broken. Investors can invest in Japan for the long-term now that shares are appropriately priced for likely economic outcomes. On the currency, we are not hedged. We have believed for at least the last year that the Yen is somewhat overvalued, and probably will weaken in the short and medium term. But, in our view, it is not so significant as to justify the risk of hedging.
Do you think there is any potential for significant revaluation of the Chinese Renminbi in 2010?
SP: I think that we are going to see some appreciation of the Renminbi but I also think that the Chinese are very much more willing to look at a gradualist approach to their currency, rather than having one-off appreciations. I think they remember what happened to Japan in the mid-1980s, when you had big movements in currencies, which ultimately contributed to a stock market bubble. I think that is probably not something that the Chinese want to repeat.
Is 8% GDP growth in China achievable this year?
SP: I think it is; but in many ways, as important as the actual number is the composition of growth. If you look at real indicators of economic growth, such as power production, they are very strong, so I think 8% growth is achievable. With regard to the composition of growth, I think we will see slightly less of an emphasis on fixed asset investment, as some of the lending growth of 2009 is reduced. But what we will see is a return of exports as being a significant contributor to the overall GDP and domestic consumption will also continue to grow in importance. So, we anticipate more balanced growth occurring in 2010.
Are there stories other than China that we should know about? Are we too fixated on China?
SP: Firstly, it is right to be fixated on China. Whether you are looking at Asia or globally, it is a major engine of growth. But, clearly there are other economic blocs in Asia which are of real importance. The obvious one is India, which is growing at around 8% and is showing different characteristics. It represents an amazing contrast between the state-led growth of China and its own much more private sector led growth. One should also look at some of the providers of commodities to China. Within Asia, Indonesia is a major exporter of, for example, palm oil for cooking. So, there are other important things happening in Asia at the moment.
Asia has traditionally been the place where investors get paid because politics does not interfere with profitability. You cannot say the same about Latin America, or Eastern Europe, specifically Russia, so how do you see the investment environment in those regions?’
DN: Firstly, I would challenge the point about investment returns. Asia has been a fantastic place to invest, but over the last 10 years the returns from Latin America and Emerging Europe have been higher. In Latin America, one of the reasons we have had strong returns has been because politics for the last seven or eight years has been very stable, creating a positive backdrop for both companies and individuals to make economic decisions. This is true in both Mexico and Colombia. Brazil has had the same government for nearly eight years and that stability has been fantastic for the economy, which will grow around 6% this year. For Russia, the credit crunch was a wakeup call. Now when I meet some of the big Russian companies, they are much more focused on shareholder returns. Crucially, the Russian government knows that it needs to make some big investments and to make those big investments, it needs foreign help.
For many emerging markets, our fear is returns are driven by capital flows, but this virtuous circle can be broken when money is repatriated, as we have seen recently, is this just a hiccup?
DN: If we go back to the fourth quarter of 2008, into early 2009, we had a big shock to the global financial and economic system. However, the emerging markets bounced back hard, and not just the stock markets, I mean the economies. I firmly believe that 10 years ago, that would not have happened. The reason is that the shake-out has highlighted where we are in emerging markets: government finances are good, debt levels are low, economic management has been sound, which contrasts with conditions in the developed world.
How is the government going to support the Japanese economy whilst battling against such high levels of debt? Also, Japan is extraordinarily indebted with an ageing population; does Japan make an unattractive economic proposition?’
PC: It has been many years since the Japanese government were able to support the economy. They increased fiscal spending slightly to try and moderate the impact of the recession, but the true turning point has come as a result of an improvement in the external environment and a pick-up in Japanese exports. In that sense, the government is not supporting the economy, nor should they be doing so because they cannot afford to do so. We are starting to enjoy a recovery both in the economy and in corporate profits, which has very little to do with fiscal stimulus. It has much more to do with a very sharp bounce-back in the external environment for Japanese exports. High levels of debt can be an impediment, but they are not necessarily a problem in themselves. Japan has had high government debt for a long time, at least the last 10 years, but in the middle of this decade it enjoyed one of the longest and strongest periods of economic expansion in the last 50 years. So clearly, high levels of debt are not necessarily impediments to growth. In terms of the ageing population that is an impediment to growth. For me the key is not to focus on whether Japan will under-perform the developed world economically, it is whether I can find companies on cheap valuations that can grow in spite of those factors. At the moment the answer is a resounding ‘Yes’.
Given Indian demographics and a more mature shareholder-orientated market, would you consider increasing Indian exposure?
SP: Those are two good points, but in the very short term India has a much bigger problem with inflation than anywhere else in Asia as the Wholesale Price Index is nudging 10%. Industrial production is also going through the roof. We would look for an increase in interest rates in the short term in order to bring things onto a more stable footing. It may be that this would allow us to buy some of the very good quality companies in India at cheaper valuations. So, while we think good things are happening longer-term, we are cautious about valuations in India in the short-term.
Will the Toyota scandal have an impact on the manufacturing sector or on the Japanese stock market?
PC: I think we can say, given that it has now been over a month since news of the Toyota recall broke, that there has not been an impact on the Japanese car industry. Sales of Japanese cars in the US since the beginning of February have not seen a knock-on impact. Toyota has suffered but the other Japanese carmakers have not. In that sense I do not think there is a wider impact. In respect of the stock market, I would simply observe that Toyota’s share price seemed to bottom very early in this crisis. It did so around a month ago, which suggests to me that for Toyota and the wider market investors view this issue as history.
If western economies are on a go-slow, how far are emerging markets insulated from that, and is that reflected in stock market valuations?
DN: In terms of valuations, Latin America has gone some of the way to reflecting its strength, but it still trades at a discount to the developed world. Emerging Europe is very interesting; it trades at a significant discount to its history and to other emerging markets, which does not reflect the true resilience of the region.
What are the historical Price-Earnings Ratios for companies in China and has economic growth already been factored in? Is China in a bubble? How much property speculation is going on?’
SP: The local A-share market, trades at around 29 times historic earnings, but it is coming down quite rapidly in 2010, to around 22 times earnings. The H-share market, of Hong Kong listed Chinese shares, is much cheaper at around 13 times this year’s earnings and we are looking at around 30% earnings growth. Against their histories these numbers are not expensive. There has been some correction in China over recent months, so it looks more sustainable in pure valuation terms and we should not forget that at the peak in 2007 the multiple of the A-share market was around 70 times.I do not think China is in a bubble as a number of the most important indicators are no cause for concern at the moment. That is not to say that if the Chinese authorities did nothing we might not get there eventually. Growing your loan books at 30% per annum, as the Chinese banks did last year, would be a bad move if you did it on an ongoing basis. However, the evidence suggests a fairly rapid slowdown in lending growth is happening.
With regard to whether there is a bubble in the property sector, I would like to compare that to some of the Western markets. If you were looking at this purely in economic terms, would you buy a property in Mayfair at the moment, when it looks expensive? In the same way, properties in central Beijing and Shanghai also look expensive but they should not be used as evidence that the whole property market is overblown. Around 25% of Chinese people buy their property with cash. Price growth last year increased by about 20%, but it fell a lot in 2008. If we continued in this vein, a bubble could inflate but I do not think it will.
Valuations in Japan look very low again, is the apparent cheapness really there?
PC: I think the apparent cheapness is there. The volatility of profits in Japan tends to be quite extensive through the cycle and in the first year of recovery it is routine to have pre-tax profit growth of 50-60%. Given that we are now in the early stages of this economic and profit recovery I think we can be fairly confident that there is some very strong profit growth ahead of us. In terms of other methods of valuation, such as relative to assets, we have just seen one of the worst years of profits for at least two decades in terms of the year-on-year change. This means there has been a lot of asset impairment and book values are depressed. In other words, these are real numbers that tell us the apparent cheapness really is there.
I would take issue with the presumption in the question, which says that Japan is cheap ‘again’. Japan has not been cheap before, and that is why I am much more excited about the valuations now than I have been at this point in previous cycles. They are genuinely depressed and priced for failure and I think there is much more likely to be success. Japanese shares are really cheap for the first time in a long time.
Some emerging market funds have been pulling back from Brazil recently. Are you seeing better opportunities in other Latin American countries, or in other regions?
DN: I still think there is a very strong investment case in Brazil. We took the opportunity to add to our investments there during the setback. Looking at other ideas I would highlight Turkey. I think there is a good chance it is five or six years behind where Brazil is today. Turkey is a big country of 77 million people. It is young and dynamic, with a strong pent-up consumer demand. After seven or eight years of political stability I think we are on the cusp of people making economic decisions such as buying a washing machine, a motorbike, or even a house for the first time. As with Brazil, interest rates are at generational lows and there is an opportunity to consolidate those strong gains via an orderly execution of monetary policy through the pick up in economic activity. I am also starting to look at Colombia, where we are beginning to see the fruits of political stability, with real encouragement to foreign investment and pent-up demand in the consumer sector.
Where are you currently positioning the Invesco Perpetual Japan fund?
PC: Our strategy has evolved as we have had greater clarity on the economic recovery in Japan over the last three quarters and also the profit recovery which is now coming through. A year ago we were comfortable with strong exporters who were enjoying growth in China and the pick-up elsewhere. Now we have moved more towards a domestic bias in our portfolio. Whereas a year ago we were looking overseas almost entirely, we now have a 50-50 split. Domestically, we are very interested in financial assets, which are where we think the best valuations are, but we retain significant exposure to the overseas environment.
Stuart, where do you see the best opportunities in Asia?
SP: We think that the whole region has considerable opportunity. The valuation of the region of around 13 times 2010 earnings is not expensive for the degree of earnings growth we will see.
Within markets, people are gradually becoming comfortable with the idea that interest rates will increase as inflation rises. We believe that the degree of interest rate tightening will not derail the recovery and so liquidity for markets will remain quite strong. I think that the medium-term themes that we have kept in the portfolio still shine out. Domestic consumption plays in the biggest economies of China, India and Indonesia still offer long-term opportunity in our view. Chinese insurers are showing huge growth and are not overvalued and they remain a focus for us.
Dean Newman (DN) is Head of Emerging Market Equities, Stuart Parks (SP) is Head of Asian Equities, and Paul Chesson (PC) is Head of Japanese Equities.