By HENRY H. MCVEY Oct 13, 2016
Beyond a rapidly changing macro outlook, the tools required to be a successful investor in Asia are changing too. As such, we think that investors may need to “pivot,” adopting a new, updated approach that might require different skills than what worked in the past. Key to our thinking is that traditional consumer penetration stories are now losing growth momentum, despite full valuation in many instances. By comparison, after five years of no corporate earnings growth across Asia, many large, diversified — and underperforming in many instances — companies are ready to rethink their footprints and strategies. This change in corporate mindset in key markets such as Japan, India, and Korea represents a new and substantial opportunity, in our view. There is also a burgeoning opportunity for leading Asian corporations that are looking to expand abroad against the backdrop of a slower Chinese economy. Finally, with GDP-per-capita still growing at high single digits or better across China, India, and Indonesia, we think that demand for value-added services, including food safety, healthcare services, and media still could have meaningful upside.
I recently joined my colleague Frances Lim, who leads the KKR Global Macro and Asset Allocation effort in Asia, on a whirlwind tour of the region. We visited a variety of cities and met with a variety of folks across both the private and public sector in an attempt to refresh our top-down view of Asia. To state the obvious, there is certainly no “one” Asia, as the region includes both large developed markets like Japan, Korea, and Australia as well as large emerging economies such as India, China, and Indonesia.
Without question, our ability to compare and contrast multiple economies across Asia provided us with what we believe are an array of important macro insights. See below for more details, but our key conclusions are as follows:
- EM Equities, including Asia, may be finally bottoming relative to DM Equities after 72 months
- Larger consumer economies across EM, Indonesia in particular, are likely to see expanded valuations in the near term
- But right now in Asia, including both EM and DM markets, we are most inclined to sell simplicity, and buy complexity
- While we remain constructive on the long-term outlook for Asia, we actually concluded our trip with the somewhat surprising view that some of the most actionable near-term opportunities in the region may not actually be domiciled in Asia
- We favor Indian Credit over Equities in a solid Prime Minister Narendra Modi-driven macro environment
- Regional risks include valuations in China’s private TMT sector as well as overreach concerns surrounding the Bank of Japan
George S. Patton
General and Senior Officer of the United States Army
Overall, we finished our trip with increased conviction that both public and private equity are poised to do well during the next three to five years. However, the opportunity set is definitely shifting; said differently, the skill set now required to generate investment success, particularly in the private markets in Asia, will be quite different than during the last cycle. It will require a more global focus, more operational expertise, and more local industry knowledge.
In terms of fixed income opportunities, we think that performing credit is likely to outperform non-performing credit in certain parts of Asia during the next one to three years. This viewpoint on credit represents a material change in our outlook. Key to our thinking is that — while the opportunity set is still substantial in the non-performing side — many governments are still dragging their feet on forcing bad loans off banks’ balance sheets and into the hands of qualified risk evaluators, including foreign investors.
By comparison, because banks are not disposing of their non-performing loans (NPLs), they are not in a great position to provide the capital required to meet the rising GDP-per-capita stories that we have been championing for several years. As such, with the economic backdrop for EM bottoming, and demand for credit now exceeding supply, we see demand for private capital by promoters and entrepreneurs solidly increasing.
Looking at the big picture, we feel that the most important take-away from our trip is that the emerging markets as an asset class have bottomed on a relative basis, something that we have not previously indicated during our tenure at KKR. EM certainly can’t detach from DM in absolute terms if there is a major slowdown, but the macro backdrop in EM is now more favorable than it has been since the turn of the century. Indeed, real rates are higher at a time when the economic cycle appears to be stabilizing, earnings have troughed, and allocations to the asset class remain modest. To this end, we think that investors should be selectively allocating more financial and human resources to uncovering opportunities in both the equity and fixed income sides of this asset class during the next three to five years.
Section II: Details
EM Equities may be finally bottoming. After 72 months of underperformance (Exhibit 1), our base case is now that EM is in the process of bottoming. We see several factors at work. For starters, we believe that the influence of local currency trends is going from being a major negative to a modest positive. This viewpoint is significant, as currency headwinds have adversely impacted EM returns by nearly 600 basis points per year each of the last five years. One can see this in Exhibit 2. Importantly, the currency headwind was coming on top of what was an extreme period of lackluster results even for local investors (Exhibits 1 and 2).
It Has Been a Long, Hard Road in EM
Currency Depreciation Has Been a Major Drag on the Total Return of Emerging Markets in Recent Years
Second, there is scope for easing, which is good for both offensive and defensive reasons. Importantly, unlike their developed market peers, the central banks of EM countries have — until recently — increased their real rates to stave off trouble. One can see this in Exhibit 3. As a result, central banks in EM now have more monetary flexibility than in the past.
Maybe more important, though, is that real rates across EM are now higher at a time when the Fed is likely to be much more dovish. To put this in perspective, just consider that the current Fed Funds rate assumes the central bank does not raise rates above one and one- half percent until after 2020 (Exhibit 4). When the taper tantrum occurred in 2013, by comparison, forward assumptions for the Fed assumed rate increases of three hundred and ninety basis points by 2020.
Real Rate Differentials Are Now Positive Across EM Markets, Which Is Quite Different Than During the Taper Tantrum in 2013
The Outlook For the Fed Today Is Now Much More Benign
In Our “Rules of the Road” Framework, Valuation and Momentum Have Become Supportive of EM Outperformance, But the Recovery Will Remain Early-Stage Until Traditional Fundamentals Strengthen
Third, most global investors are now underweight EM as an asset class. In hindsight, a conservative stance has been warranted because — in addition to currency issues and real rate issues — corporate earnings growth in the region has actually been flat to negative for five consecutive years1.
On a prospective basis, however, we are more constructive on EM as an asset class. Supporting this fundamental view is our quantitative dashboard for EM, which one can see in Exhibit 5. While not every indicator has turned upward, many are now headed in right direction.
Earnings Per Share in EM Asia Now Appear to Be Bottoming
Mutual Funds Currently Hold Significant Underweight Positions in Big EM Markets Like China
Our bottom line: We think that earnings are bottoming, ownership of EM is well below benchmark, and valuations are much more attractive. This more positive viewpoint is consistent with what we heard from CIO’s at our Chief Investment Officer Symposium, which listed the emerging market recovery story as the most important investment theme for the next three to five years. It also supports our bigger picture view that EM economies may have already bottomed before DM economies this cycle.
Given Higher Real and Nominal Yields, We Think That EM Debt Could Outperform Too in Today’s Low Rate Environment
Larger consumer economies across EM, Asia in particular, are likely to see expanded valuations in the near term. In today’s post Brexit environment, we are of the mindset that investors will continue to shun globalization stories in favor of domestic consumption stories, higher value added services in particular. No doubt, the U.S. — with 68% of its economy linked to consumption — should prosper (Exhibit 9).
However, several EM countries should fare well too. Indeed, as we show in Exhibit 9, three economies — Indonesia, India, and Mexico — have, on average, a full 62% of their economies, or $2.5 trillion in absolute buying power, linked to domestic consumption, which should provide them with more of a buffer than many other countries to the slowdown in trade, cross-border flows, and China growth that we continue to forecast. In aggregate, emerging markets consumption has grown 245% since 2003 and EM’s share of total global consumption has increased 16 percentage points since 2003 as GDP-per-capita has fueled a boom in experiences and value-added services (Exhibit 12).
In Addition to the U.S., We Believe Investors Will Seek out Large EM Consumption Stories in the Coming Years.
As a Macro Theme, We See Global Capital Supporting/Improving Valuations in Large Domestic Economies
GDP-Per-Capita Growth Is Expected to Fuel the Demand for More Services in the Coming Decades
Total EM Consumption is Now Growing 3x as Fast as Total DM Consumption
But right now in Asia, including both EM and DM, we think the biggest investment arbitrage is to sell simplicity and buy complexity. While we remain constructive on long-term consumption trends, many companies that target this area of the Asian economy now appear expensive. In particular, we think that consumer stories linked to maturing penetration stories appear overpriced relative to their forward looking growth rates. One can see this in Exhibit 15, which shows that Chinese consumer staples companies are trading at essentially one-standard deviation above normal.
By comparison, we actually think that there is currently a major opportunity for change to carve-outs in Asian conglomerates that have over-diversified across industries and/or overestimated the opportunity within an industry. In our view, complexity of story appears cheap on a relative basis in today’s low rate, slower growth environment. Nowhere is this investment set more intriguing right now than in Japan, in our view. Indeed, as Exhibit 14 shows, many companies are trading at extremely favorable enterprise values to EBITDA. Moreover, rates are low, banks need to lend, and many firms require the requisite expertise to help them expand abroad.
We Believe That There Is Great Potential for Operational Improvement in Japan…
...At a Time When Valuations Are Attractive in Many Instances
In China, Defensive Stocks With Earnings Visibility Are Now Trading Quite Rich In Many Instances
Banks in Large Asian Markets Like Japan Are Overweight Deposits, But Underweight Lending Opportunities
The other big attraction for us goes back to operational improvement. Indeed, if one just applies a simple Dupont analysis to Japanese corporates, one can see that there is notable room for improvement across all three levers: margins, turns, and leverage. One can see the potential magnitude of the upside relative to history in Exhibit 13. Among the three (margins, asset turns, and leverage), we are most enthusiastic about the potential for the revenues-to-assets ratio to improve.
Outside of Japan, we see similar carve out opportunities in both Korea and Australia, two other large developed economies within the region. Interestingly, though, we talked to several executives and financial services leaders in India who underscored a similar opportunity set. Specifically, in too many instances ambitious promoters have expanded too fast and too far across multiple industries, causing them to shed assets to pay down debt, avoid a ratings downgrade, and/or improve returns.
While we remain constructive on the long-term outlook for Asia, we actually concluded our trip with the somewhat surprising view that some of the most actionable near-term opportunities in the region may not actually be domiciled in Asia. Since we began visiting the region in 1995, the bull case on Asia has always been that China — representing about one-third to one-half of global GDP growth — would boost GDPper-capita across the region for an extended period of time. What is actually unfolding today, however, is quite different. For starters, China’s growth is slowing, particularly on a nominal basis. One can see this in Exhibits 17 and 18, respectively. As such, many executives in Asia are now looking for new markets to bolster growth across their existing product suite. In addition, many EM corporate executives with whom we spoke believe that there are best practices they can acquire overseas and bring back to their domestic markets.
Nominal GDP Growth in China Has Fallen a Full 12.4 ppt In Absolute Terms Since 2Q11, While Real GDP Growth Has Slipped a More Modest 3.3 ppt
Significant Monetary and Fiscal Stimulus Has Boosted GDP Growth in China of Late
Somewhat ironically, the loudest drumbeat that we hear about international expansion within Asia is now coming from the China corporate sector. As such, we think that there is an emerging opportunity, particular for global private equity firms and certain multinationals, to partner with Asian companies, Chinese ones in particular, looking to expand abroad. In many instances, European and U.S. firms can provide local knowledge about consumer behavior, help to overcome regulatory hurdles, and teach operational best practices. Chinese firms will also need help with mergers and acquisitions, which should drive incremental need for local strategic advice, financings, and management talent.
China’s Influence Has Risen to 25% of Global M&A, Exceeding That of the U.S.
China Is on a Mega Buyout Spree
China Has Finally Rebalanced Towards Higher Value Add Exports…
...Not Surprisingly, China Is Now Gaining Market Share in Strategically Important Global Industries
India: Credit over Equities in a solid Modi-driven macro environment. We left India with two important take-aways. First, we think that, while the Modi euphoria has abated since our last visit, the broad consensus is that the current government is steadily making solid progress. Key initiatives include the Goods & Services Tax (GST), major anti-corruption initiatives, and an ongoing clean-up of the financial services industry. We also spent time with the folks who are designing and implementing the new bankruptcy laws, and while not perfect, they appear to be a major step in the right direction for a process that previously took too many years to resolve, involved too many players along the way, and often yielded too little in terms of actual results.
Indian GDP Growth Remains Amongst the Highest in the World
…And the Trend Should Continue
Urban Consumer Demand in India Has Been Generally Strong…
…And Rural Demand Is Now Recovering
Maybe more important, though, is that the consumer in India is gaining momentum across both rural and urban areas. Without question, the forward-looking Indian consumer story will be shaped by its 440 million Millennials and its 390 million Generation Z’s (born in year 2000 or after). To understand things in perspective, we note that India’s GDP-per-capita — at US$1,650 in 2015 — is now comparable to China in 20052. From what we can tell, however, a different approach to tap into this market will be required to achieve success relative to what happened in China during its initial consumer boom cycle. Specifically, India’s spending will likely be driven by its urban mass consumers (130 million plus with GDP-per-capita of $3,200) versus China, which was driven by a more upscale urban middle class that drove spending from 2002-20123. In fact, India’s urban middle class ($11,000 GDP-per-capita annual income) is now just 27 million, or just two percent of the population, compared to 150 million in China, according to the investment bank Goldman Sachs.
To be sure, not everything is headed in the right direction in India. There are certainly growing concerns about Pakistan from a security perspective as well as disappointment surrounding the failure of the land bill. Also, there is some handwringing over whether the new head of the Reserve Bank of India, Urjit Patel, will succumb to pressure from other parts of the government. That said, compared to what we see in many other economies, India stands out for its relatively benign outlook as well as the fact that, with its large consumer economy, the country is dependent primarily on itself for success versus having to rely on the rest of the global economy for growth.
India Has a High Cost of Equity…
Second, similar to our last trip, we think that, all else being equal, debt appears more attractive than equities in India. In particular, we continue to see a burgeoning opportunity across performing private credit, and we do wonder why more investors — many of whom are aggressively increasing allocations to liquid EM corporate debt — are not looking towards the private credit markets. If either the U.S. or Europe is any proxy, then we think this transition/growth could surprise market participants sooner than expected.
...But Private Debt Probably Provides the Best Risk-Adjusted Return
If Underwritten Properly, Private EM Debt Screens Quite Attractively, Relative to Liquid Corporate EM Debt
Regional risks include China’s private TMT sector as well as over-reach risk by Bank of Japan. After a long series of high level meetings across both the public and private sector, we came away thinking about three risks that may not be fully appreciated by investors. First, given the rush of high net worth and speculative institutional money into private investments in China (particularly around the New Economy) during recent quarters, it is clear to us that — similar to what happened in the U.S. — private growth investing in China is likely overheated, suggesting lower valuations are now in store for many private, IPO-seeking companies. In some instances we think that valuations need to fall at least 20-30% before either a new round of capital or an IPO could be considered. If we are right about our concerns, then it would be somewhat ironic, as the large majority of investors with whom we speak actually seem much more worried about the Chinese public equity market, despite many stocks in the public indexes currently trading at single-digit multiples.
The Chinese Government Is Using the Offshore Overnight Rate to Periodically Cool Speculation
Second, there was again concern from the “Authorities” with whom we spoke that the Chinese government is still not willing to make the hard changes required to structurally improve its outlook. Indeed, during our visit we really just heard more about how recent stimulus will revive China’s stock market in the near term, not concrete plans to curb credit growth and/or clamp down on fixed investment excesses. In fact, China is actually moving in the opposite direction with many of its policies, including a recent surge in fiscal stimulus. All told, China is now outlaying 11-13% of GDP on government and regional spending, which dwarfs almost anything we have seen in the past. One can see this in Exhibit 31. As Exhibit 32 shows, infrastructure remains the primary beneficiary of this most recent surge in government spending.
China Is Now Running a Deficit of Between 11-13% of Its GDP Because of Heavy Central and Regional Government Spending…
…Which Likely Contributed to a Rebound in Infrastructure Investment This Year
In addition, the government is trying to improve the cost of capital for the corporate sector quickly by allowing more capital to flow towards key areas of the economy. For example, the government recently allowed Chinese insurance companies to start to buy high dividend yielding equities in Hong Kong, which we believe has materially boosted valuations for financial services companies, particularly ahead of important capital raising exercises in its banking sector. By comparison, we heard little about tightening policies around NPL recognition or improving lending standards.
No doubt, all the aforementioned tactical shifts by the government are near-term positive developments for China’s capital markets and the country’s GDP growth rate. However, we think more structural work needs to be done, particularly if China wants to grow its capital markets (which we think is necessary to offset intensifying capital flight). To this end, we think it would be good for a few state-owned enterprises to be restructured with the help of outside investors. A similar story holds true in the market for non-performing loans. Our bottom line: to really attract the sticky capital required to cleanse the heavily indebted corporate sector, we believe more transparency and more structural reform is needed.
Third, there is a growing concern that Japan’s monetary policy may ultimately backfire. Just consider that Japan’s central bank already holds QE assets equal to 90% of GDP (and it is still adding assets at the pace of roughly 16-17% of GDP per year), that the Bank of Japan currently buys almost 100% of gross issuance, and it already owns 38% of the entire JGBs in the market4. So, on the one hand, if the Bank of Japan slows its buying, the growth in the aggregate monetary base would slow, which would be viewed negatively for future growth prospects. On the other hand, if the Bank of Japan does not slow down purchases, then it will essentially own the whole market within a few years. Frankly, we worry more about the latter outcome than the former because it would underscore that Japan had done everything it could to re-ignite its economy using monetary stimulus and it was still not working. Either way, it is clear that we are reaching the limits of monetary policy from a variety of vantage points in Japan at this point in the cycle. As in most countries we track, reforms tend to take longer to implement. However, in the case of Japan, the need for measures to improve productivity is more urgent than ever.
Section III: Conclusion
Our recent trip to Asia underscored to us why Asia is one of the most dynamic regions—if not the most dynamic region—in the global economy. Why? Because beyond a rapidly changing macro outlook, the tools required to be a successful investor in Asia are changing too. For starters, traditional consumer penetration stories are now losing growth momentum, despite what we believe is full valuation in many instances. By comparison, after five years of no corporate earnings growth across Asia5, many large, diversified — and underperforming in many instances — companies are ready to rethink their footprints and strategies. In our humble opinion, this change in corporate mindset in key markets such as Japan, India, and Korea represents a new and substantial opportunity, particularly for investors who are willing to take a more industrialist approaches to their ownership stakes.
There is also a new and growing opportunity for leading Asian corporations that are looking to expand abroad against the backdrop of a slower Chinese economy. Finally, with GDP-per-capita still growing at high single digits or better across China, India, and Indonesia, we think that demand for value-added services, including food safety, healthcare services, and media still could have meaningful upside. To be sure, our high conviction about investment opportunities in the higher value-added areas of the emerging Asian economy is not “new” news, but solidly rising GDP-per capita in many of the areas that we visited only reinforces our conviction.
Given the dynamic nature of the region, there are also important risks to consider. In our view, China is still clearly growing its debt levels at too rapid a clip, and its private TMT sector appears somewhere between modestly and massively overvalued. Meanwhile, in Japan, its central bank appears to be getting close to reaching its limits, something that many investors have never even had to ponder before. We also think that geopolitical flare-ups across India, China, and Japan are likely to gain more momentum in the coming quarters.
Overall, though, we left Asia with the sense that — in today’s low rate, low growth environment that defines the asynchronous global economy in which we operate — both public and equities and parts of private credit are likely to deliver above-average returns over the next three to five years for global investors, particularly those with broad mandates and multiple touch points in the region. If we are right, then we are in the early innings of a notable change in flows and performance that all global investors may want to incorporate into their thinking.