Could Reforms Lead to Asia Rerating?

Hayden Briscoe

Asia’s three biggest economies—China, India and Japan—are carrying out reform programs. Taken individually, these may do little to excite investors’ imaginations, but taken together, they become much more interesting.

The three countries seeking growth through reforms (Display) collectively account for nearly 40% of the world’s population. If the proposed reforms are only half successful, it could be enough, in our view, to lead investors to positively rerate each country—and Asia generally.

China

The 60-point economic and financial reform program announced by China last November made headlines, but it has intrigued and perplexed investors rather than inspired them. Most investors remain focused on China’s gross domestic product (GDP) growth—still high by world standards but continuing to moderate. But slower growth should be viewed in the context of China’s broad policy objectives. These include deleveraging—particularly in sectors such as property, which expanded rapidly in response to fiscal stimulus during the financial crisis.

Slower growth is helpful in that respect, although China wants to keep it from slowing too much. Accordingly, the government has taken steps to ease policy selectively. For example, it has strategically favored sectors such as agriculture and infrastructure—also targeted by the reform plan—putting a floor under growth while promoting economic reform.

India

The landslide election of Narendra Modi as India’s new prime minister in May fueled strong rallies in Indian equities, US-dollar bonds and the rupee. But the government faces considerable challenges. India’s growth fundamentals have deteriorated over the last 10 years, with worsening fiscal and current account deficits as well as stagflation—low growth with high inflation—over the last four.

The failure of previous governments to address these challenges means that a lot rides on Modi’s ability to lead effectively. He built a strong track record of growth and reform as Gujarat’s longest-serving chief minister, from 2001 to 2014. We have a clear view of the steps needed to get India’s economy back on track and the order in which they should be taken: a decline in domestic oil prices first, followed by a narrower trade deficit, lower inflation and then important fiscal reform.

Given the current challenges, we’re cautious about predicting any easy victories for the new government. But we’re far more inclined to give the benefit of the doubt to Modi than we were to any previous prime minister: if anyone can succeed, we think he can. In a country of 1.2 billion people, many in extreme poverty, the implications of successful reform and rejuvenated growth could be profound—not just for India and the region, but globally.

Japan

The “three arrows” recovery plan announced 18 months ago by incoming Prime Minister Shinzo Abe—aggressive monetary easing, massive fiscal stimulus and structural reform—has begun to find its mark even though only the first two arrows have been fired.

Monetary easing has pushed the yen down sharply. The fragile state of the global economy has prevented this from translating into significant export growth, but it has boosted exporters’ profit margins, leading to higher wages and investment. Fiscal stimulus has spurred construction growth. This includes rebuilding in Tohoku, the area affected by the 2011 earthquake and tsunami, and reinvesting in aging infrastructure. The lead-up to the 2020 Olympic Games in Tokyo will provide more work.

These policies—combined with accelerated retail spending ahead of an increase in the value-added-tax rate in April—produced relatively strong GDP growth of 2.8% for the 12 months ending March 2014.

Japan now faces two questions: Is it doing enough at a policy level to sustain organic growth without the third arrow of structural reform? And if structural reform comes, will it further extend organic growth? We think organic growth is enough to expand the economy at a reasonable rate for the next 12–18 months. The potential for upside growth surprise seems low, but that might change with aggressive structural reform.

Things Are Looking Up for Asia

The three countries we discussed, and Asia overall, already seem to be better investments than developed Europe or other emerging markets, particularly eastern Europe.

From a fixed-income perspective, regional inflation has fallen and should stay low for the foreseeable future. Bonds, in our view, are fairly priced. We expect currencies to continue trading narrowly, creating opportunities for active investors to add value. Interest-rate differences should offer the potential for attractive yield-carry strategies.

Asian economies and markets have a lot in common that differentiates them from other emerging regions. We think this is a reason to consider Asia separately within emerging-market and global allocations. We also expect positive medium-term investment narratives from reform programs. Add these up, and we see very strong potential for a significant upward rerating of the region.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Hayden Briscoe is Director of Asia-Pacific Fixed Income at AllianceBernstein (NYSE:AB).

2 comments

  1. I”d be interested to know how far you would expect the re-rating to take Japan for example, given the already strong gains show by the Stock Market?

    • Hayden Briscoe

      Good question, Gary-

      While it’s true that expectations for Japan’s economic growth and the performance of its stock market are higher now than when Prime Minister Abe came to power, we think there is still scope for upside surprise, for three reasons.

      Firstly, the potential for Abe’s reforms to succeed continues to be widely underrated, in our view. The Bank of Japan has shifted inflation expectations, wages and capital spending are improving, and we expect to see a response in export performance to the weaker yen. This underpins our own stronger-than-consensus views with regard to inflation and growth.

      Secondly, a more coherent narrative is beginning to develop around some aspects of Abe’s “third arrow”—that is, structural reforms affecting corporations and investment institutions, the implementation of which promises to be positive for return on equity.

      Thirdly, Japanese equity valuations in terms of price-to-earnings and price-to-book are not stretched, in our view, in comparison either to current global valuations or historic Japanese valuations. Valuation spreads are relatively wide, too. This suggests opportunities for active investment managers and potential upside for the broader Japanese market.

      While we do not expect a rerating that would replicate, for example, the surge in the Nikkei that took place after Abe’s re-election in December 2012, we regard today’s relatively high expectations for Japan’s economy and stock markets as reasonably soundly based.

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