Chips falling into place for an Asian equity rally

markets (EMs) are off to a flying start this year.

Latin American and Eastern European stock markets are up more than 10 per cent year-todate, significantly outperforming their United States and other developed market counterparts. However, Asian markets have lagged. There are increasing signs that the disconnect between Asia and other EMs may not last much longer.

We believe there are three major signposts to look out for in an Asian equity market catch-up rally, some of which have started to flash green.

The primary building block for a recovery in EM assets following last year’s reversals was put in place by the US Federal Reserve (Fed) at its meeting in December last year. The US central bank acknowledged that US financial conditions had tightened to a point where they could afford to be “patient” and examine the impact on domestic economic activity.

A “patient” Fed is good news for EMs and Asia because it halts the once-growing divergence in monetary policy between the Fed and the rest of the world. As US policy re-synchronises with the world, albeit temporarily, the US dollar is likely to reverse some of last year’s gains. A softer US dollar in turn enables EM financial conditions to loosen, while encouraging institutional investors to shift funds to EM assets.

We see early indications of this phenomenon — EM equity markets have so far seen the strongest fund inflows since the first two months of last year. A prolonged Fed pause on rates, which is likely to hold well into the middle of the year given contained US inflation, could accelerate the flows and the EM equity rally.

Asia is likely to particularly benefit from the renewed inflows if a second condition is met — namely, China steps up its support for its economy. Over the past few months, Beijing has not only shelved its plans to deleverage the economy and tighten environmental and other regulations (at least for now), it appears to have done a U-turn in policy and shifted focus to supporting growth.

China’s policymakers have cut bank reserve requirements, eased credit support for small and medium companies, cut personal and corporate tax rates and eased rules for local governments to issue more bonds to finance infrastructure projects, while fast-tracking their regulatory approvals. We believe they are likely to help stabilise growth in the coming months and aid a recovery by the second half.

China’s coordinated, growthboosting measures are a key reason why China is our preferred equity market within Asia. Moreover, China’s onshore equity market is trading below its long-term average valuation of 11 times 12month forward earnings and is close to historical lows, making it attractive within Asia.

There is also an important distinction between China’s current policy measures and those in the past which has investment implications — the latest stimulus measures are mostly directed at boosting domestic consumption, whereas the investment-driven stimulus measures of the past benefited global suppliers of key commodities. Given this, the latest policies make China’s domestic-focused consumer discretionary sector particularly attractive for investors.

Lastly, any resolution, or even a thaw, in the ongoing US-China trade disputes would be a crucial building block for a sustainable rally in Asian equities this year. There are hopeful signs here.

For one, there seems to be growing understanding in the US administration that a prolonged trade war might be damaging for the US economy itself.

Hence, we see the growing willingness among the two sides to avoid further escalation of the titfor-tat tariff war and to reach a negotiated settlement. We believe one way forward would be for the two sides to separate their disputes over intellectual property from the broader trade imbalances. China has already pledged to boost imports of aircraft, automobiles, energy and agricultural commodities from the US in the coming years.

These steps should help narrow the US-China trade gap over the coming decade.

For sure, the challenges against a sustained revival in risk assets in EMs remain non-trivial. The global economic cycle is mature; the Fed may yet resume rate hikes as domestic labour markets continue to tighten; China’s high debt levels mean it faces structural impediments against significantly pump-priming growth; and the intellectual property disputes between China and the US may become more entrenched.

These risks justify a broadly diversified approach to investing, with exposure to stocks, government and corporate bonds, gold and other alternative assets. Nevertheless, we see the stage being set for Asian equities to catch up with other EMs and outperform global equities over the coming year.

A ‘patient’ Fed is good news for EMs and Asia because it halts the once-growing divergence in monetary policy between the Fed and the rest of the world. As US policy resynchronises with the world, albeit temporarily, the US dollar is likely to reverse some of last year’s gains.

Steve Brice is chief investment strategist at Standard Chartered Private Bank.