We still see mid-to-high single-digit upside for Asian ex-Japan equities this year, despite revising down earnings growth estimates from 6.6% to 5.7% on cyclical tech weakness. Our rationale is that the market’s attractive valuation, diminishing currency and policy headwinds, and strong dividend support should drive a re-rating.
We lowered our 2019 earnings growth estimates for Asia ex-Japan (AxJ) as a whole from 6.6% to 5.7%, with estimates largely unchanged for the rest of the region, including China. A bulk of the overall downward revision came from Asia’s cyclical technology industries, which are struggling because weak smartphone demand has caused a sharp deterioration in the fundamentals of global hardware and semiconductor supply chains.
But with Asia still trading at only 1.4x its price-to-book (P/B) ratio, compared to the 2018 peak of 1.9x and crisis levels of 1.2x, we see strong valuation support for Asian equities thanks to diminishing currency and policy headwinds and strong dividend yields.
First, Asian markets were rattled by multiple issues in 2018, ranging from weakening currencies and regulatory concerns for new economy industries to, most importantly, trade tensions between the US and China. While some of these headwinds will likely persist throughout 2019, those remaining should diminish in severity or fade away. For instance, regulatory concerns are gradually subsiding in China’s new-economy industries like gaming, as evidenced by the recent resumption of approvals for new video game titles. Our view on regulations has been that the intention of the Chinese government is not to deter, let alone to damage, innovative or online business models. Instead, regulations are intended to prevent excesses, improve user protection, and drive healthier and more sustainable growth. And after a strict 12 months, we believe Chinese regulators will gradually take their foot off the regulatory pedal.
Second, with most Asian currencies depreciating against the US dollar in 2018, currency headwinds accounted for almost one-fifth of Asia’s 14.4% decline last year, according to our estimates. While we expect Asian currencies to stay relatively weak against the greenback in the near term, we forecast them to stay flat for the full year, thereby eliminating currency-related headwinds for the region. And while trade tensions between China and the US may stay elevated for the foreseeable future, the 90-day truce announced in December and recent positive announcements from both sides give us hope that Washington and Beijing will postpone the implementation of recent sanctions pronouncements.
Third, driven by strong free cash flow generation, Asian businesses have been steadily increasing dividend payouts over the past years. While we doubt payouts will rise further in the near term due to macro uncertainty, Asia’s dividend yield is now close to historical highs of more than 3% thanks to last year’s market rout. Over the past decade, barring the 2008–09 financial crisis, AxJ’s dividend yield has risen above 3% only two times: during the 2011 US debt-downgrade saga and the 2016 China-driven sell-off. Interestingly, during the two previous instances, markets rebounded by 5–10% in the six months after AxJ’s dividend yield crossed 3%. Today, most Asian markets offer attractive dividend yields, with some offering close to 5%.
As such, with investor expectations generally low for Asia, we maintain our constructive view on regional equities. We think investors will be best rewarded by continuing to invest in a diversified group of technology leaders and financials in the region. Within Asia tech, we advise staying away from cyclical segments such as semiconductors and hardware due to the lack of compelling product cycles and overall weak consumer electronics demand. Instead, we see opportunities in internet due to stabilizing growth and abating regulatory headwinds. On financials, we think their attractive valuations and high dividend yields offer investors a superior risk-reward compared to other sectors. Earnings growth is likely to remain decent at mid- to-high single digits, after an estimated 10% rise last year, in our view.