At the start of the year, Lyxor viewed Asia as a potential equity hotspot. With everything selling off, it's been hard to keep sight of that in recent weeks, but the fundamentals - a weaker US dollar, Chinese growth, and global recovery - remain as sound now as they were then.
Asia equities have reacted to the S&P correction and rising volatility, but they seem less concerned by rising treasury yields. As long as the USD doesn't start to appreciate like it did between 2011 and the end of 2016, it should continue to provide support: less need for rate hikes to prop up currencies, lower USD debt servicing ratios, and more foreign inflows. Now is a good time to look at these markets through the lens of the greenback weakness - after all growth, inflation, and rate hikes had many expecting the opposite. The experience has been jarring, but what if it's only temporary?
At the very least, there can be no complacency when investing in Asia. These markets aren't homogeneous, given varying degrees of political risk and their different sector make-ups, so your search for opportunity may be more demanding. Valuations may be more appealing when the dust settles on this correction, particularly in Japan, but some caution is needed - some markets are more expensive than others, have more of their borrowing in dollars, and are more exposed to currency gyrations.
The graphic below covers our latest thoughts on key Asian markets and the correlation between local indices and the strength or otherwise of their currencies vs. the USD. The higher the number, the more a market tends to rise when the local currency is strong and the dollar is weak. The results aren't always what you might expect - most people see South Korea as an export-driven economy like Japan, but the correlation between the Korean won and the MSCI Korea Index is actually positive (i.e. equity markets perform better when KRW strengthens), unlike that of the yen and the MSCI Japan.
Asia markets: Outlook & correlation with local currency moves
Asian markets have reacted to the S&P correction and rising volatility, but have a good combination of improving fundamentals, moderate valuations, and still reasonable liquidity - as long as the USD does not strengthen. China may not continue on the stellar trajectory of last year, but both FX and growth have stabilised, meaning its economy is the anchor of markets in the region. We favour the consumption and domestic stories.
The sell-off doesn't undermine our positive view on Japan. Growth looks strong, as do earnings, and monetary policy remains largely out of sync with developed market central banks. Post-correction valuations look appealing. We focus on domestic sectors, excluding financials.
Chinese equities benefit from robust equity flows (through southbound on the offshore market), the positive perception of reforms, and an only gradual growth slowdown. But we are neutral on the market given some concerns over valuations, particularly of growth stocks. We do not expect China to outperform broader indices this year.
South Korea +0.53
In our view, South Korea still offers the greatest value in AXJ. The earnings growth surge and signs of improving governance have triggered a market re-rating. North Korea tail risk appears to have receded for now.
Earnings growth has taken a pause, having been disrupted by demonetisation and the implementation of the goods and sales tax. Consumption growth is resuming and volume growth picking-up. We are tactically underweight. We expect the lull in outperformance to continue but reform progress shouldn't be underestimated.
Indonesian growth has been largely disappointing, despite signs of strength at the back end of 2017. Domestic consumption and credit growth remains weak, but earnings growth has generally met analyst estimates. Reforms are planned, but their implementation appears challenging.
Growth momentum is strong and earnings are showing signs of life, notably in the domestic part of the market. Financials in particular should benefit. Factor in an improved current account surplus and you can see why we favour Thai equities.
ASEAN - Malaysia +0.437
Growth momentum is improving, earnings are getting better, and politics could become less uncertain after forthcoming elections in Thailand and Malaysia. The domestic story is strong.
Source: Lyxor & SG Equity Strategy, Bloomberg. 15 February 2018. Past performance is no guide to future returns. Data is based on 10yr monthly correlations for MSCI indices on each market to end January 2018.