Have You Missed the Rally?

Heading into the final quarter of 2017, we reflect on markets that have rallied strongly, valuations that have remained reasonable and earnings that were robust. Many skeptical investors may still ask: “Have we missed the rally?”

Let’s first consider that markets may have rallied strongly this year, but people have already forgotten the extent to which they sold down amid fears investors had over the new U.S. administration’s plans to impose import tariffs and possibly start a trade war with China. There were also concerns that tax cuts and infrastructure spending would cause the U.S. dollar to strengthen and interest rates to rise. Furthermore, despite strong economic growth and a rebound in earnings, Asia ex Japan earnings are only a meager 1% above where they were in July 2011. So I think it’s too soon to be talking about having missed the rally.

I’ve argued that Asia’s earnings growth is likely to outpace that of the U.S. in the near and medium terms, and that of Europe in the medium term. My view has been predicated on the idea that wages have lagged productivity growth in the West, leading to expanding corporate margins. As a consequence of deliberate policy, however, wages have increased faster than productivity in much of Asia, leading to thinner corporate margins. Further, these policy changes are petering out and governments will seek moderately inflationary policies that may restore more of a balance between the worker and the capitalist; improve corporate margins; and lead to better returns in equity markets. How does the environment look now? Are things progressing as we expected? What will the likely future impact on markets be?

So far this year, we’ve seen minimum wage policies in China and elsewhere in Asia ease to the point that wages are no longer outstripping productivity. South Korea remains an outlier here with a potential for further wage hikes. But by and large, Asia’s wages have not gobbled up more than their fair share of the economic pie. We have seen central banks reflating—starting around 2013 with the Bank of Japan, and more recently, China has joined the Japanese. While China will occasionally take administrative measures against overheating in the property market (and potentially equities too), it has managed to drive core inflation from 1.5% at the beginning of 2016 to 2.2% now. In both countries, corporate margins, cash flows and earnings have improved. Subsequently, equity markets have rallied. Further evidence of the spread of reflationary policies has come from a surprise cut in interest rates by Indonesia’s central bank. Despite this, the currency has remained stable.

This is the final element some find worrying—if Asia stimulates as the U.S. tightens and economic growth in the eurozone causes its central bank to muse about “tapering,” won’t that hurt Asia’s currencies? But don’t forget that this already took place! That is what the devaluations in 2013 were about. Currencies took a further hit after the election of President Trump. But this year, they have steadied and rallied. With current account surpluses growing and deficits shrinking across the region, and many Asian nations with inflation rates below the 2% level that the U.S. Federal Reserve targets, the fundamental backdrop for Asia’s currencies looks much less risky. Indonesia’s central bank noted this fact. And if Indonesia can ease monetary policy, other Asian countries which have much stronger current accounts and lower structural inflation can certainly do so, too.

And how have markets reacted? I would say that they have paid more attention to the reflationary policy than to earnings improvement. As such, it has been the companies that are growing the fastest—sometimes irrespective of valuations—that have performed the best. In some cases, companies have embellished their fundamental businesses with “new economy” jargon that reminds me of previous occasions when the markets have become overexcited. But this time, the extent to which buzzwords are now being used to dress up otherwise unexciting businesses is nowhere as prevalent as this was during, for example, the dot.com years—and there are some great Asian internet companies to own.

But I believe that if Asia’s earnings continue to grow as I expect, the market will not just chase blindly some of these large-capitalization growth companies but will start to see the opportunities in value names and in small- and mid-cap companies. There may be an element here that as people chase benchmarks and ETFs, there has been forced buying of some equities regardless of fundamentals, as some investors have warned. Asia’s highly valued counterparts of so-called FANG companies—Facebook, Amazon, Netflix and Google—account for a good chunk of the information technology’s weights in the benchmark, now at almost one-third. However, I still believe markets as a whole to be quite reasonably valued, given that earnings have been weak for years and have a good chance of growing strongly over the medium term. This leads me to suspect that investment styles that either have an element of value or focus on the mid- and small-cap sectors of the market (or potentially both) are likely to have some tailwinds for relative returns in future years.