18 April 2024

Since the Global Financial Crisis, globalisation appears to have slowed. Indeed, despite the enormous benefits experienced in the post-WWII era, international trade and financial flows may have gone into reverse (Chart above). In addition, following disruptions caused by the Covid pandemic, some manufacturers have shifted supply chains to domestic producers, or at least alternatives closer to home. Populist leaders on all continents have attempted to capitalise on concerns that the benefits of globalisation have not been widely shared.

Global geo-political tensions have reinforced this trend. Russia’s invasion of Ukraine has led European nations (and others) to reconsider their sources of energy. And, the US and western allies have pressured other countries to limit commercial ties with Russia. Perhaps even more importantly, the US-China trade war is significantly disrupting trade between the two nations. The deterioriation in Sino-US relations and the Ukraine war have led to speculation the world is splitting into two camps: western, liberal demoocracies and those with authoritarian leadership.

Again, this has prompted some multinational corporations to relocate production back home (“reshoring”) or to move to more politically-aligned areas (“friend-shoring”). While perhaps politically inevitable, all nations are losers from deglobalisation (Chart above).

During the past nine months, I have recommended building overweight positions in Emerging Markets, especially in Asia ex-China. During this interval, EM ex-China markets have kept pace with developed markets ex-USA, but have lagged the S&P 500. However, the IMF estimates the trade-oriented Asian economies are amongst the most vulnerable to deglobalisation (Chart above). Have Asian nations begun to take sides in the US-China feud? As China’s regional dominance grows, who would be the most effected? Does this derail the case for investing in Asian equities?

Asia: Are Countries Taking Sides?

To be sure, certain Asian countries, e.g. Taiwan and the Philippines in particular, confront explicit risks as China exerts its regional geo-political dominance. However, no nation will want to “take sides” if US-China relations continue to deteriorate, and each will juggle bilateral ties with both countries. Nevertheless, the Chart above illustrates potential vulnerabilities. In terms of exports, several countries export more to the USA than to China, e.g. India, Vietnam, and Thailand. On the other extreme, Indonesia, Australia, and even Korea and Taiwan are more reliant on China compared to the American market. Japan, Malaysia, and the Philippines are more diversified. The picture on the import side, however, is quite different. All Asian economies, except Taiwan, are more dependent on Chinese products than on those from the USA. The gap is most noticeable in Indonesia, Vietnam, Thailand, Malaysia, the Philippines, and even Japan.

As the Sino-US trade war has intensified, nations have responded differently. For example, Vietnam, Thailand, Taiwan, and Korea have benefited from the sharp reduction in US imports from China — the share of each country’s exports destined to the USA have risen since 2019 (Chart above). In Korea and Taiwan, however, the share of exports to China have fallen, perhaps reflecting cooling bilateral ties with their large neighbour. Meanwhile, the share of Indonesian and Australian exports headed for China has risen during this period. In terms of imports, the American penetration of all Asian makets has declined during this interval. At the same time, China’s involvement in most Asian markets has deepened, especially in Vietnam and Thailand as regional supply chains have shifted.

In addition to these geopolitical considerations, the trade-oriented Asian economies are vulnerable to the currently tepid pace of global growth. Recent regional trade performance has been highly varied. On the one hand, exports from China, Indonesia, Australia, and India have been weak. Meanwhile, however, foreign sales momentum has improved in Vietnam, Taiwan, the Philippines, and Thailand (Chart above).

The Investment Case for Asia: Still Intact

Resilient Demand Offsets Global Risks

Confronted with these global growth risks, is the Asian investment case still in tact? Asian GDP should remain resilient, especially in countries with large domestic markets and expanding consumer demand. These conditions exist in Vietnam, Indonesia, and India, as well as Malaysia, the Philippines and Thailand. This contrast starkly with developed economies, especially in Europe and Japan where the cost of living crisis has constrained household spending.

Inflation: Low, Declining, and Less Sticky

In most Asian countries, inflation is low and declining, and “core” readings are already below central bank targets (Chart above). Indeed, China and Thailand are teetering on the brink of deflation. In contrast, in the United States (and to a lesser extent in other advanced economies), the final phase of the disinflation process is proving to be challenging. To be sure, I expect US price growth to slow towards the Fed’s 2% target over the next 12-18 months. However, US “core” inflation has been “sticky”, largely reflecting rising service sector prices. As the service sector is not as large in most Asian countries, this complication has been less relevant.

Consequently, Asian central banks should begin lowering interest rates this Summer. Again, in contrast, US markets are beginning to reconsider their earlier optimism about the pace of Federal Reserve rate cuts, which may be delayed into the Autumn or beyond.

Asian equity markets fare best when global interest rates are declining (especially those in the USA), and the US dollar is depreciating. In both cases, gratification appears likely to be delayed for longer than anticipated.

Fiscal Space: More Room to Maneuver

In its recently released 2024 Economic Outlook, the IMF focused considerable attention on the perilous state of public finances worldwide. To be sure, certain Asian nations confront serious challenges. In contrast to the USA and Japan, however, most Asian government deficits remain quite small even after Covid-related spending (Chart above), especially in Korea, Taiwan, Australia, Indonesia, and Vietnam. India and China (especially) are outliers.

Arguably, the difference is even more striking in terms of government debt. In the USA and Japan, public sector liabilities are not only very high, but are rising in an unsustainable fashion (Chart above). In contrast, in most Asian nations debt levels are manageable, and are even declining in Vietnam and Taiwan. Again, China and India are noteably important outliers.

Asia’s healthier public finances could have economic and financial market implications in the years ahead. On the one hand, this year’s busy global electoral calendar likely rules out fiscal belt-tightening in high-debt countries in 2024. However, financial market volatility could force policymakers to address this issue in an emergency situation. Asia should be relatively immune to this risk.

Moreover, coping with large budget shortfalls will be a headwind for large-deficit countries beginning next year. Again, this is less relevant in Asia. On the other hand, if global economic growth falters in coming years, Asian goverments would have more stimulative fiscal options compared to counterparts in the USA, Japan, and Europe. China’s budget deficit may limit its options more than is generally acknowledged.

Valuation: Even Cheaper than Usual

Relecting lower profitability, Asian markets traditionally trade at a discount to developed markets, especially the USA. Nevertheless, Asian valuations now appear relatively attractive, especially compared to the US market (Chart above). Given the adverse regional sentiment resulting from the collapsing Chinese equity market, the extremely undemanding valuation of Chinese stocks is especially noteworthy.

Strategic Implications

To be sure, the US election is likely to involve lots of tough talk on China. Nevertheless, I believe Asian markets (and EM overall) will outperform developed markets during the next 12-36 months. I especially favour Indonesia, Vietnam, India, and the Philippines, and I’m less excouraged by Taiwan, Korea, Thailand, and China. (I recommend visiting my blog Archive for individual articles on China, Japan, and India).