Market Review
The benchmark MSCI AC Asia Pacific ex-Japan ticked up slightly by +0.5% in Euros during the fourth quarter and is up by +2.6% for the calendar year.
Under the hood of a flattish market, the most important market of Hong Kong and China, saw a decline of over 8% for the calendar year in the Hang Seng index, and more than 16% for the last half year. A composite of China property bonds declined by over a third, illustrating the stresses in that sector. Southeast Asia was up c. 2.5% in the fourth quarter.
China remains committed to its “Zero Covid” strategy, which is effectively keeping the country shut, which appears to suit President Xi. While the Covid picture is mixed across Asian countries, as a generalization we are seeing a reopening of the regional economies ex-China since around September, albeit interrupted by fears over the Omicron variant. Crucially, the urban centres even in developing economies are vaccinated at Western levels, and public life including shopping malls and traffic jams are returning. Most countries are on a credible vaccination path.
A key question going forward is whether the less lethal Omicron variant is the beginning of the end of the pandemic. Not only do we all wish for that scenario, but in economic terms, a full reopening of Western economies would accelerate the return from goods-consumption to service-led growth, potentially reducing the strain on goods supply chains.
Performance Review
The increased China exposure that the fund carried since the summer continued to hurt performance. This past quarter, the fund experienced reversals of prior gains in renewable energy amid minor policy headwinds and a general downdraft in HK-listed China equities. However, this theme has been a long-term winner, and is expected to remain as such as investors remain increasingly comfortable in backing the green energy transition in China.
Like in the third quarter, a (modest) real estate exposure became a drag as this sector continued to experience severe policy-driven headwinds. The fund started to invest in beaten down property companies in the past two quarters, in particular in the asset light and cash flow generative property management sector. While this wasn’t rewarded in relative performance, it is notable that with the exception of Shimao, the portfolio has successfully sidestepped the sector names in severe financial distress. The fund never owned the dubious names like Evergrande, Kaisa, or Fantasia. We are seeing news every week of the strong and well-capitalized companies picking up the in-progress development projects of those weaker firms.
So-called “value” stocks in China have continued to de-rate, but at price-to-earnings multiples of around five for the MSCI’s “old economy” measure, these are at their lowest absolute valuations and are setting up an incredible margin of safety. Southeast Asia remains dramatically cheap relative to emerging markets and Asia as a whole.
Outlook and Strategy
We are seeing signs that four major market drivers are turning this year, and the portfolio should be setup to benefit. For China, several tea leaf readings of policy suggest that following a very tight 2021, the year 2022 will see looser policy across the spectrum, emphasizing stability leading up to October’s party forum.
China monetary conditions during 2021 were among the tightest, and tighter even than 2008. China has decidedly gone looser, kicked off with the January interest rate cuts. For 2022, we can see a loosening China PBoC and a tightening US Federal Reserve, the exact reverse of the last two years. Various (second hand, but consistent) accounts of the key Central Economic Work Conference (CEWC) in December further attest to this shift and hint at a possible uptick in Total Social Financing - in other words an increase in credit in the economy and a sequentially positive credit impulse.
China regulatory policies have been very constricting on various fronts. The travails of the property sector are directly attributable to tightening regulations since 2018, most famously the “three red lines” that restricted new borrowing in a sector that had become overindebted and too dependent on ever faster asset turns. The government remained almost stubbornly tightfisted throughout 2021, but in December showed first signs of loosening. In January restrictions for developers on their use of customer prepayments were relaxed, and combined with earlier announcements on mortgages, give credence to the thesis that 2022 will allow the best players in the sector the breathing room to take advantage.
The one exception to the “China relaxation” trend is likely the technology sector, as China only this week vowed to further curb the “influence of technology companies and root out corruption tied to the disorderly expansion of capital”, which we have to interpret as code for a further reigning in of market dominance (and potential political threat) of the big technology platforms and their billionaire owners.
Southeast Asian equities have historically done relatively well against broader Asia in the 3 months following the onset of US rate hiking cycles according to an analysis by Goldman strategists. We observe that since autumn, the expected number of rate hikes for 2021 – as predicted by futures markets – has increased from around zero to four, or just under 100bps, with the March meeting potentially seeing the first hike. Past evidence suggests that ASEAN (and Korea) should be relative winners.
In the last letter we concluded that in the event of rate rises, “while long duration valuations on the Nasdaq would be at risk, (short duration) value in emerging markets may have its time.” These comments were echoed by investment legend Jeremy Grantham in GMO’s latest piece on what they analyze as a 2-sigma “bubble” in U.S. equities. Grantham wrote that “a summary might be to avoid U.S. equities and emphasize the value stocks of emerging markets”. Year to date stock market performance lends credence to this recommendation.
Florian Weidinger, Santa Lucia Asset Management Pte Ltd