During the third quarter, the People’s Bank of China (PBOC) remained in active easing mode and Japan’s Nikkei 225 Index reached a 27-year high. Supportive monetary policy and strong momentum can often be positive indicators for markets. However, in our analysis of recent events and likely catalysts for future direction, the Invesco International and Global Growth team continues to seek opportunities but believes both markets face obstacles that could impact future performance.
China – weaker macro trends may create volatility
The Chinese economy was already slowing before the start of the trade tensions with the U.S. However, with the rhetoric picking up more strongly than anticipated, economists began to nudge down their forecasts for gross domestic product. On top of the trade concerns, China is also in a deleveraging phase, leading to weaker macro trends. As a result, the People’s Bank of China (PBOC) has been easing, cutting the reserve requirement four times since Sept. 2017. With China easing and the U.S. hiking rates, the Chinese currency fell nearly 4% against the dollar just in the last quarter.1
Looking back to 2017, many investors were flooding into expensive momentum stocks. These stocks peaked in the first quarter of 2018, were mostly flat over the second quarter, and finally experienced the major selloff we had been anticipating during the last quarter. For example, last year’s regional darling stock, Tencent, was down close to 18% (in U.S. dollar terms) in the three months ending Sept. 30 while JD.Com was down over 30% over the same period1 (neither company was owned by Invesco International Growth Fund as of Sept. 30, 2018).
Outlook on China
Overall, we are bullish on the Chinese consumer over the long term as China transitions from a primarily export-driven country to a consumption-driven country. However, we could see some short-term volatility, which may create additional bottom-up opportunities for our Earnings, Quality and Valuation (EQV) approach.
During the third quarter we added Yum China Holdings (0.49% of Invesco International Growth Fund as of Sept. 30, 2018). This company operates KFC in China, making it the number one quick service restaurant (QSR) operator in the country (they also own Pizza Hut, the number three restaurant chain in China). Quick serve restaurants are highly underpenetrated in China, which is driving high single digit (and accelerating) earnings growth. What makes this even more interesting is that Yum China is generating significant free cash flow (FCF) despite aggressive store build-outs. On valuation, the company has a high free cash flow yield of 5% to 6%, net cash equaling about 20% of its market value, and it generates a return on equity (ROE) of 20%.1
Looking forward – here are three key takeaways on China’s market:
1. Although the outlook can change quickly, at the moment we don’t see any end to U.S.-China trade tensions. China is still much too strong to “beg for mercy” from President Donald Trump’s tariffs.
2. The data suggest that the Chinese authorities will continue to provide stimulus to keep the economy and the consumer on track.
3. Now that stock prices and valuations have come down, we are evaluating some high-quality names that have become more attractive from a valuation perspective.
Overall, Asia (ex-Japan) has recently seen negative earnings revisions. We believe this is due to a deteriorating macro outlook (amplified by the geo-political tension between China and the U.S.), regulatory changes in industries like education and online lending and a weakening outlook for the exchange rate.
Japan – government buying supports equities
Japanese equities (represented by the Nikkei 225 Index) posted a 3.6% return during the third quarter. However, with the yen simultaneously weakening by about 2% over the same period, the net return of the broader market fell to 3.5% in U.S. dollar terms.1 Currently, our team remains underweight in Japan because we believe there are relatively few high-quality names with upside potential. In addition, there is the added complication of the upcoming consumption tax hike in 2019 (8% to 10%) which we see as a form of fiscal tightening. In our view, this can’t help but have a negative impact on the already fragile Japanese economy.
While revisions for Japanese companies have been positive for both revenue and earnings, we see this as being linked to the weakening yen. In the past six months, the yen has fallen nearly 7% in U.S. dollar terms.1 Given the likely path of U.S. interest rate policy, we don’t see this dynamic reversing anytime soon.
Outlook on Japan
For us, there wasn’t much in the way of fundamental change in the third quarter, and little is expected near-term. In our opinion, Japan’s current governance levels are weak by global standards, and company ROEs are still around 3.5% below global averages.2
With that said, Japanese valuations are more optically compelling than the global average, with an average PE of 13.5x for the next 12 months versus a growth benchmark average of 17x. However, the lower valuation is also a result of a weak growth outlook. Earnings per share growth for Japan over the next 12 months is projected to be a paltry 3% versus the benchmark of 12.5%.2
So the question must be asked – given these lackluster metrics, how have Japanese equities held up so well? The Nikkei 225 Index rose 3.5% in the third quarter and hit a multi-decade high, while the rest of the world (as represented by the MSCI ACWI ex-US Index) basically traded sideways (up 0.71%).2
Looking forward – two key takeaways on Japan
We see two primary drivers behind the recent relative outperformance of Japanese equities. Both are related to supportive government policies.
1. The Japanese pension system (known as the Government Pension Investment Fund) has increased its allocation to Japanese equities. Currently, over 25% of the entire fund is invested in Japanese stocks.3
2. Back in July, the Bank of Japan decided to nearly double its purchases of exchange-traded funds that track the Nikkei 225 Index.
So, stock prices in Japan have essentially been kept high due to government policies that effectively propped up the market. Eventually, there will come a time where Japanese equities will have to sink or swim based on fundamentals. Our bottom-up investment decisions are always based on our EQV strategy, which seeks to find quality growth companies with long-term investment potential.