Investors began 2018 with a generally optimistic view, but this euphoria faded by quarter-end as protectionism and talk of a U.S./China trade war became a key concern. Despite investor pessimism, we expect further volatility might create the opportunity to invest in high-quality Asian equities at lower valuations.
Market volatility spiked as U.S. President Donald Trump started delivering on a campaign promise to rework “bad” trade deals struck by his predecessors. First, he announced tariffs on Chinese steel and aluminum. Then, he announced plans for a 25% tariff on US$60 billion of mainly high-tech products from China1 relating to intellectual property rights.
As expected, China retaliated by threatening to add an additional 25% levy on about US$50 billion of U.S. imports including soybeans, automobiles, chemicals and aircraft.2 More recently, it was reported that Trump is considering an additional US$100 billion in tariffs on selected Chinese goods.3
Much ado about nothing?
Through their recent actions, we see the U.S. and China both attempting to stake out strong positions before heading to the negotiating table. For China, the immediate impact is expected to be small – we estimate these tariffs will apply to only about 2.7% of the country’s total global exports. The initial damage to the Chinese economy could be a minor reduction in gross domestic product (GDP) of between 0.1% and 0.2%.4 However, the medium-term impact will likely be mitigated by export diversification. With China’s GDP predicted to grow at 6% to 6.5%5 for the next few years, the impact of these tariffs is expected to be barely perceptible even if fully implemented.
That said, the headlines and risk of a trade war certainly contributed to volatility and weakened investor appetite of late, especially considering the market’s strong performance in 2017.
Conditions in China
Despite the market volatility in the first quarter, Asian companies overall (ex Japan) saw strong positive revenue and earnings revisions. These were driven primarily by upward guidance by companies in China – rising over 11% in the past six months.6
Interestingly, the revisions during the last quarter were more positive for momentum and growth stocks than for quality and value stocks. Quality stocks often initially underperform in economic upturns because stable earnings usually lag behind cyclical stocks with rapidly accelerating earnings.
At the end of the first quarter, China’s price-to-earnings ratio (P/E) for the next 12 months was approximately 12.5x,6 which the Invesco International and Global Growth team considers attractive and is well below the broad market of both international (non-U.S.) developed and emerging market growth companies as measured by the MSCI ACWI ex USA Growth Index ratio of 17x.6
Conditions in Japan
The Japanese yen has strengthened 5.7% this year against the U.S. dollar, while the Nikkei 225 Index has remained flat in local currency terms5 as “Abenomics” continues to struggle to deliver on its target of 2% inflation. Please note that a strengthening currency is generally bad for export-driven economies like Japan.
Earnings revisions for Japan were some of the strongest globally, linked to a host of reasons such as improvements in capacity utilization as a result of weak capacity growth, industrial output, as well as yen distortions. However, from our perspective, fundamentally little has changed. Japan’s current governance levels are ranked amongst the lowest in the world (according to Thomson Reuters Datastream ESG data), while company return on equity metrics are still about 400 basis points below global averages.6
That said, valuations are starting to look more compelling, with an average P/E ratio of 13x versus that of the broad market of both international (non-U.S.) developed and emerging market growth companies at 17x.6
Our EQV approach
The Invesco International and Global Growth team seeks companies with attractive Earnings, Quality and Valuation (EQV) traits. With the possibility of further volatility, we believe our approach may benefit investors for the following reasons:
- High-quality companies have the ability to adapt to the environment even if geopolitical concerns erupt
- We believe quality companies tend to fare better during volatility
- Quality and valuation may become more important to investors, should volatility remain high
We were able to add several new companies in China during the first-quarter selloff, including Henan Shuanghui Investment & Development Co. Ltd. (China’s largest processed pork producer) and Wuliangye Yibin Co. (a Chinese spirits manufacturer)(0.75% and 0.60% of Invesco International Growth Class, respectively, as of March 31, 2018) Both are in the consumer staples space and both have very strong brands and high market share. These two companies were also holdings of Invesco Canadian Premier Growth Fund as of that date, at 0.77% and 0.59% of assets, respectively.
In Japan, while there are still relatively few high-quality companies trading at attractive valuations, the increased volatility gave us the opportunity to add a new consumer staple name, Asahi Group Holdings Ltd., during the quarter (0.75% of Invesco International Growth Class as of March 31, 2018).
Looking forward, we welcome further volatility as it could increase the possibility of adding new companies at attractive valuations.