Why US Protectionism Will Not Quash Opportunities in Asia ex Japan Equities

Anik Sen
Global Head of Equities
New York

Elizabeth Soon, CFA
Portfolio Manager and Head of Asia ex-Japan Equities
Hong Kong

10 March 2017

During his campaign, US President Donald Trump took a tough stance on trade with China, including threatening to increase tariffs on Chinese imports. Now, there is speculation on a so-called border adjustment tax (BAT) as part of a wide-ranging reform of US taxation, one of the anticipated defining pillars of the current US administration. China is the largest trading partner of the US, responsible for more than 50% of imported consumer goods. New tariffs and taxes on trade threaten to reverse the decades-long progress of globalization of commerce under the aegis of the World Trade Organization (WTO). All politics aside, equity investors may find themselves concerned, as such trade restrictions could affect economic growth globally and have far-reaching consequences on many industries and companies.

While the US withdrew from the Trans-Pacific Partnership (TPP) just days after President Trump took office, there are no firm trade or tax proposals on the table yet. Our view is that the administration intends to make US companies more competitive globally by significantly lowering the headline US corporate tax rate, which is among the highest in the world, so that these companies are better able to invest and create jobs freely without tax distortions. While the trade deficit with China is likely to be driving the rhetoric on taxes and tariffs, higher level political objectives may also be at play in the Asia-Pacific region that could further complicate and lengthen the path to establishing firm proposals.

Uncertainties abound on the final outcome of US taxation policy and on the Trump administration’s stance toward China with respect to tariffs. They will likely take some time to be dispelled, and the potential for a negative feedback loop back into the US also complicates matters. Yet we believe that the Asia ex Japan equity market in general – and many Asia-based companies in particular – stand out as providing attractive opportunities for investors no matter how these policies unfold in the US.

The finalized tariff and tax arrangements are likely to take time and be softer than feared

The current tax rules have resulted in large cash balances of US companies being perpetually held abroad in foreign financial systems. The BAT proposal is expected to remove the deduction of the cost of imported goods in calculating taxable income, while exports would be US tax-exempt and only taxed by foreign governments. Both the BAT and the proposal to lower the US corporate tax rate are likely intended to remove the friction that companies encounter when repatriating their foreign earnings back to the US to be invested in creating new productive capacity and jobs.

However, the BAT proposal could have adverse consequences for many industries, particularly low-margin retailers in the US that import the vast majority of their merchandise. These companies may not be able to pass on the additional cost imposed by the BAT to consumers. And if they can, that could have the unintended consequence of reducing consumer spending, a driver of US economic growth. Investors’ concern, then, is that this cost may be transferred back into the supply chain.

This may not be as easy as it sounds. Suppliers in Asia ex Japan are now embedded in US companies’ global supply chains, often from the initial design stages, and are likely to resist since they have broadened their client bases away from the US. There are few, if any, alternative suppliers with the necessary scale and technological edge to take their place in the supply chain. While some jobs filled by workers in Asia at high-tech companies could be brought to the US to avoid the BAT, the process will likely take time and may not be commercially viable.

Due to the complexity involved in making such sweeping changes, the Asia ex Japan equity markets have responded with a wait-and-see attitude. Negotiations are likely to be lengthy with many twists and turns, since the unintended consequences of a hasty rollout of new tax arrangements could be economically and politically damaging. Isolating individual products is likely to prove to be as complex as isolating individual countries for an acrossthe- board increase in tariffs. We believe the BAT is a complex issue to solve in a relatively short time frame, and that changing trading arrangements with a trading partner as large as China is likely to be equally complex, with retaliatory measures and damaging effects for both parties. Consequently, we think any potential increase in tariffs and/or import costs that may come down the road are likely to be benign in order to avoid a negative economic feedback loop into the US economy.

Countries and Industries Facing the Biggest Risk From Protectionist Trade Policies
Top goods exported to other countries (as % of total US import from that country)

Protectionist Trade Policies, Top exported good by country

Source: Barclays Research, January 2017.

Why equity investors should turn to Asia ex Japan

With or without the trade issues brewing in the US, we see a window of opportunity to invest in Asia ex Japan.

Since 2010, Asia ex Japan has underperformed developed market equities by more than 25%, as measured by the MSCI All Country Asia ex Japan Index versus the MSCI World Index. Indeed, flows are still generally in favor of developed markets. But going forward, we expect equity valuations to be more supported in Asia ex Japan as the earnings cycle picks up from its trough. This is due to both global cyclical growth and long-term secular growth in the vast Asia-Pacific region.

Despite an underlying agreement in the market that nominal global growth is expected to accelerate, driven largely by the US and Asia, investors currently hold an unusually high level of cash in their portfolios. The Global Fund Manager Survey from Bank of America Merrill Lynch as of January 2017 shows that the average cash balance held in portfolios was 5.1%, significantly higher than the 3.5%-4.5% levels during most of the past 15 years. This suggests that, on average, fund managers are taking a cautious stance – and are poised to buy on market weakness. At the same time, the Asia ex Japan equity market is trading at a significant discount to developed market equities despite a strengthening fundamental picture.

Asia ex Japan May Be Poised for a Rebound
Based on Forward P/E Ratios

Investing in Asia ex Japan

Source: FactSet, January 2017.

Invest from the bottom up

The universe of opportunities is wide, valuations are increasingly supportive, and trends in technology and demographics make Asia ex Japan equities an attractive asset class within an emerging market allocation. However, the best investment approach is not just broad exposure to the Asia ex Japan region, in our view. To pick the best companies – including those less exposed to US trade risk – we think investors should take a bottom-up approach that considers several factors.

Identify investments that tap into the region’s potential

Companies in Asia ex Japan are the beneficiaries of the largest historical surge in prosperity in terms of human numbers. The Asia ex Japan region is now very close to the US in terms of nominal GDP, and both China and India are leading the global growth rates. The sharp increase in China’s wealth has led it to become the second-largest economy in the world, behind the US, in a little over a decade. And China’s growth appears to have become secure in recent months, with good execution of policy and an upturn in inflation. In India, strong political and economic leadership and a purposeful reform agenda are securing its rapid growth for the long term.

There is a great deal of potential in the region in terms of urbanization, demographics, energy, and more. Infrastructure development is a broad investment opportunity spanning materials, machinery, and technology. Lifestyle changes related to growing affluence among Asia ex Japan’s large and relatively young populations touch many types of companies, including consumer discretionary, clean energy, and financial services.

Asia ex Japan Economies Have Grown to Be On Par With the US

Asia ex Japan Economies

Source: International Monetary Fund (IMF), Morgan Stanley Research dated 13 February 2017. Note: AXJ includes China, Hong Kong, India, Indonesia, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand.

We expect domestic demand to continue to improve, helping the consumer retail sector – particularly in China. Southeast Asia’s expanding middle class will also provide a strong market for branded consumer goods. This rapidly growing segment is spending money on mobile phones, internet access, and online shopping, often through smartphone apps such as WeChat, as the region’s tech sector becomes increasingly consumer-led. Some of the fastest growing sectors have been in technology, media, tourism (both outbound and inbound), and telecommunications.

Finally, government initiatives are driving huge leaps in consumer technology. In India, the government’s demonetization program and its individual identification number project known as “Aadhaar,” which covers more than 1.1 billion residents and is considered the world’s largest such project, have jump-started the country’s progress in consumer technology as the need for electronic payment functionality grows.

Focus on the shift toward technology

Over the last 30 years, many companies in Asia ex Japan have evolved from their roles as purely manufacturers. Low-cost manufacturing in Asia has shifted toward lower labor-cost countries while the higher cost countries, now including China, have climbed the value chain in producing higher valueadded products and services. In their pursuit of innovation, reliable quality, and timeliness in delivery, multinational brands will continue to depend on Asian manufacturers – they really have no choice.

China and India are playing key roles in the region’s developing prosperity and economic path. Both countries are rapidly developing value-added industries, deploying technologies from more advanced neighbors, such as South Korea and Taiwan, and shedding labor-intensive industries to emerging or frontier countries, such as Indonesia and Bangladesh. China, once highly reliant on labor, has made impressive progress in automation. Corporate investors are also taking notice as foreign direct investment is flowing into automation and robotics.

When selecting stocks, we particularly like companies we call “branded original equipment manufacturers” (OEMs). Branded OEMs are building barriers to entry with the specialization they have gained through the ramp-up in research and development (R&D) over the last decade, where the ratio of spending to sales has been approaching that of the US. These companies are among the market leaders in their specialized industries and have obtained a leading edge through a relatively long period of spending in R&D.

The Ratio of R&D Spending to Sales for Asian Companies Has Increased Considerably

R&D Spending in Asian Companies

Source: Bloomberg, 9 February 2017.

Focus on management expertise

We look for strong management teams that are positioning their companies to have high barriers to entry through scale, R&D, a broad and global customer base, and a strong financial position. Indeed, these are the companies that have become so ingrained in the manufacturing supply chain that we view them as virtually inseparable from their multinational partners. In this region, we believe it is important that investors are able to meet with the management teams – not just once, but periodically over time to gain a deeper familiarity with the strategy and operational delivery of a business. For example, a local investment team in Asia may have as many as 1,000 management meetings in a year, but the vast majority of these would be repeat meetings, resulting in a high-conviction investment approach.

A diverse market with strong potential

We view the Asian equity markets as attractive as an asset class within emerging markets. Asia ex Japan equities, particularly small and midcaps, offer unique plays on innovative, technology-driven companies with strong management teams and healthy financial positions. These companies are embedded in the supply chain of multinationals, and benefit from global growth as well as from secular growth in the Asia-Pacific region.

However, to find the best opportunities and avoid the weaker ones, investors will need to employ strong bottom-up research and selectivity. Asia ex Japan’s size and diversity mean investors need to have local teams and processes in place that help them recognize which companies are the best at what they do and, simultaneously, are best positioned to capitalize on their strengths.