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2016's crucial factors for Japan, Asia and Emerging Markets
Amid China volatility and its global repercussions, a panel of investment experts discusses the political and economic dynamics they think will steer Japanese, Asia-Pacific and Emerging Markets in the coming year.
Japan's economy is a "work in progress" that hasn't lived up to its promise, according to Jeremy Lawson, senior international economist at Standard Life. Will this be the year it finally breaks out of more than 20 years of sluggish GDP growth and rock-bottom inflation, trending to deflation?
The year 2015 was not auspicious: Japan fell back into a technical recession and prices remained low. Lawson thinks progress on the three arrows of the Abenomics recovery programme being implemented by Japanese president Shinzo Abe - fiscal stimulus, monetary easing and structural reform - has not been dramatic enough.
The reform agenda has been modest so far, so potential for growth remains weak. The monetary stimulus has been one of the biggest employed by any government, but inflation remains low. Further quantitative easing (QE) is likely to be needed.
'The Japanese equity market has made good gains, but the performance of the domestic economy has been inconsistent.'"The question is, how committed is the government to doing everything needed to get the rate of growth higher?" asks Lawson. "The Bank of Japan is also finding it difficult to meet its 2% inflation objective as quickly as it should have," he adds.
Paul Chesson, head of Japanese equities at Invesco Perpetual, says: "While we've been bullish in our outlook for Japan for some time, the current environment presents us with a more mixed picture for 2016, so the message is more nuanced.
"The Japanese equity market has made good gains over the past few years, but the performance of the domestic economy has been inconsistent. The major contributors to growth have struggled to achieve sustainable improvement since the consumption tax hike in April 2014.
"Consumption has been undermined by slower-than-expected improvement in wages, with an increase in social security contributions negating part of the rise in incomes."
Chesson adds that a further tax hike planned for April 2017 is likely to introduce additional volatility into the consumption outlook. "The expansionary fiscal policy of the Abe government shortly after its election victory at the end of 2012 has given way to a more neutral stance.
"Pressure is now growing for a supplementary budget to give the economy a short-term boost. Against this background, speculation has mounted that the Bank of Japan might undertake a third round of QE."
Signs of progress
Nicholas Price, portfolio manager of Fidelity Japanese Values (FJV), thinks the reform agenda is showing signs of progress. He says: "The desire for reform in Japan remains firm, and the corporate sector is changing for the better. Japanese companies are committed to improving capital efficiency and returns on equity, and many in my portfolio are actively utilising free cash flow for shareholder returns. Old companies such as Hitachi and Mitsubishi Heavy Industries are refocusing on core competencies, and cash-rich corporates are starting to deploy more of their surplus funds for investments.
"A key focus of my investment approach is detecting signs of change. The rapid growth in inbound tourism - a surprisingly underdeveloped industry, given the comprehensive and high-quality service culture in Japan - is one such change that will continue to provide attractive investment opportunities in 2016."
'The rapid growth in inbound tourism will provide attractive investment opportunities in 2016.'Price says that, given the impact of population decline on domestic demand, the government aims to increase the number of tourists visiting Japan to 20 million a year by 2020 by easing visa requirements and expanding tax-free shopping.
He adds: "A wide range of firms across Japan are benefiting from the surge in tourist demand: from resort and hotel operators to department stores and electronics retailers. Revenue growth from inbound traffic is increasing rapidly."
Nicholas Weindling, fund manager of JPMorgan Japanese investment trust (JFJ), agrees that corporate Japan looks attractive. "Our portfolio is currently set up for a low-growth environment globally, and our holdings offer long-term structural growth. They include companies with strong brands, beneficiaries of rising inbound tourism, and winners in the ageing society."
Niven thinks there is a "good argument" that Japanese and European companies will make more progress than US firms this year. He points out that Japanese and European companies have lower margins than those in the US, "so there is potential for a recovery", and Japanese businesses also trade at lower multiples.
'Japanese and European companies will make more progress than US firms this year.'Weindling agrees. He says: "The Japanese stockmarket trades on a price-to-earnings (PE) ratio of 15.6 times, based on forecasts for fiscal-year 2015 earnings. This is cheaper than the US and Europe, which trade on a PE of 18.3 and 16.1 times, respectively.
"The outlook for Japanese equities is positive, driven by relatively better earnings growth, increasing focus on shareholder returns and fair valuations."
Asia Pacific ex Japan
After a relatively strong 2014, the Asia Pacific ex Japan region suffered a reversal last year as fears over a weakening Chinese economy and a looming interest rate rise in the US weighed heavily on the currencies and stockmarkets of most Asian countries.
The exception to this rule, perhaps surprisingly, was China. Despite suffering losses of up to 30% between June and August, the spectacular gains seen in the run-up to the summer crash meant the Shanghai Composite index was up more than 10% over the calendar year to 3 December and up 28% over the 12 months to 30 November.
However, with economic data continuing to disappoint, the Chinese market is unlikely to fare well this year - though few expect the hard landing that commentators have been predicting for the country over the past two to three years.
David Coombs, head of multi-asset at Rathbones, says he expects annual GDP growth in China to bottom-out at around 5.5% next year from its current level of around 7%. He says this is "enough to support global growth alongside a strong US economy".
Neil Williams, chief economist at Hermes Investment Management, agrees. He adds that even with a - highly unlikely - fall in GDP growth to 3%, the Chinese economy would still be adding $1.3 trillion (£860 billion) to the global economy, which is equivalent to the total GDP of Spain.
Moreover, many China experts say the slowdown in Chinese GDP indicates that the government's drive toward a domestic, consumer-led economy, as opposed to one reliant on foreign investment in infrastructure and banking, is on track. Jade Fu, investment manager at Heartwood Investment Management, says: "We have long held the view that if China is to achieve the transition towards greater domestic demand, the likely impact would be for the economy to slow in certain areas and grow in others.
"Recent data has provided evidence of this unfolding: a slowdown in the manufacturing and industrial sectors compares with healthy services and retail sales activity."
Fellow Asian powerhouse India also experienced a disappointing 2015. In the calendar year to 3 December, the MSCI India index shed 2.8%, as the euphoria that boosted markets by around 30% in 2014 following the election of reformist prime minister Narendra Modi faded.
While faith in Modi to deliver on the structural reforms he was elected to implement remains fairly strong, investors are becoming increasingly frustrated by the slow pace of economic change.
'Increasing likelihood of an interest rate rise in the US led to a depreciation of the rupee.'Moreover, like many Asian and emerging nations, India has been negatively affected by the increasing likelihood of an interest rate rise in the US, which has led many foreign investors to withdraw swathes of money from India as they prepare to reinvest at home. This has led to depreciation of the Indian rupee. The currency fell by 2.4% in November alone as foreign investors withdrew $1.5 billion from Indian stocks and bonds.
Despite this, most investors remain positive on India, including Coombs. He says: "We still like India, which is growing rapidly: between July and September India's GDP grew by an impressive 7.4%. It is benefiting from being a net importer of energy and industrial commodities, the cost of which has fallen sharply over the past 18 months."
Asia Pacific is dominated by China and India, but it has plenty more to offer. Andrew Swan, head of Asian equities at BlackRock, observes that Asian markets are becoming differentiated. He says: "There has been a lot of dispersion in Asia, and this is important for the long-term outlook. There is a good chance markets will still fear the Fed and China in 2016, but ultimately those factors are overstated, because Asia is changing.
'Markets will still fear the Fed and China in 2016, but those factors are overstated as Asia is changing.'"There will be winners and losers, and investors will get their returns by picking the right countries, sectors and stocks."
While Asia still tends to trade more or less as a bloc, Swan says differences in the economic drivers in individual countries are beginning to emerge via returns. For example, while Singapore's market shed 14% in 2015, similarly-placed Taiwan and Korea shed only 5.5% and 0.3% respectively.
He argues that investors interested in Asia would therefore do well to pay attention to individual countries' economic, political and industrial drivers in future, rather than simply focusing on what is happening in the US and China.
Global emerging markets took a pounding in 2015. In the calendar year to 3 December, the MSCI Emerging Markets index shed 8.4%, which has pushed its three-year return down to a loss of nearly 6%. Again, fear of a Fed rate hike and China's slowdown were largely to blame for the region's poor performance, which in index-weighted terms is dominated by China, South Korea, Taiwan and India.
Outside of the big four emerging Asian nations, lower commodity prices, political turmoil and weak currencies all played a role in diminishing returns.
Nowhere was this more evident than in Brazil, where the Bovespa index shed an eye-watering 35.5% in the calendar year to 3 December. As one of the world's top commodity producers - particularly of iron ore and oil - Brazil has suffered heavily from lower global prices and reduced demand from China. Meanwhile, the Petrobras corruption scandal refuses to fade, and president Dilma Rousseff faces impeachment as a result.
'Without reform efforts or coherent policy, 2016 will be another disappointing and negative year for growth.'Brazil's GDP contracted by 4.5% in the third quarter of 2015 compared with the same period in 2014. Only five out of 12 economic sectors showed marginal growth. Consequently, many people are pessimistic about Brazil's economy in the short to medium term, including Craig Botham, emerging markets economist at Schroders.
As Botham explains: "Hopes that the rapidly worsening economic situation would force politicians to act have been scotched, as opposition parties push for president Rousseff 's impeachment. Without reform efforts or anything resembling coherent policy, 2016 is set to be another disappointing and negative year for growth."
Colm McDonagh, head of emerging market debt at Insight Investment, gives an equally bleak prognosis for Brazil's currency: "In the past three years the real has depreciated by about 50% against the dollar. A weaker currency will not help Brazil, which has a history of high inflation and limited room to manoeuvre."
Argentina has faced similar troubles to Brazil's recently. With energy and mining accounting for more than 4% of GDP, the country has also suffered from lower commodity prices. Meanwhile, a populist government akin to Brazil's has weighed heavily on economic progress and investor sentiment.
However, in November 2015 Argentina received a shot in the arm in the form of a new, market-friendly government led by Mauricio Macri. As a result, Argentina was one of the strongest developing markets in 2015. The MSCI Argentina index returned close to 6% in the calendar year to 3 December, thanks to a sharp rally in the lead-up to Macri's election.
Most observers now have high hopes for Argentina, including John Malloy, emerging markets equities portfolio manager at RWC. He says: "If Macri's policies are applied successfully, Argentina should perform well, given the significant potential of some of its industries.
"Banks, for example, have strong growth potential, given that domestic lending is lower than in Brazil, while Argentinians are, on average, wealthier."
Markets in Russia performed surprisingly well last year, with the MSCI Russia index returning more than 19% in the 12 months to 3 December, making it one of the best-performing markets in the world over the period.
'Russia is dependent on commodities, so the fall in prices has been painful and will likely continue to be.'Russia is viewed with scepticism by most investors because of the unpredictability of its quasi-dictator, Vladimir Putin, and the corruption entrenched in its biggest companies. However, investors were tempted by bargains created by steep sell-offs following Russia's "invasion" of Ukraine in 2014, which prompted economic sanctions from the West, and markets have responded positively to signs that the West may remove the sanctions in January.
That said, Russia's heavy reliance on commodities and its recession-hit economy make it a risky bet for 2016. "Russia is very dependent on commodities, so the fall in commodity prices has been painful and will likely continue to be," says Sam Lees, head of funds research at fundexpert.co.uk.
He adds: "Indeed, with global growth predicted to be just 2.3% in 2015 and recessions ongoing in Russia and Brazil, the outlook for emerging markets as a whole is not stellar."
But others believe lower valuations in emerging markets present buying opportunities. Jorry Rask Nøddekær, manager of the Nordea 1 Emerging Stars Equity fund, says: "We see low growth levels being priced into many emerging markets over the medium term, and we think the asset class should generate good returns over the next year or more.
"As an investor, you need to start to 'load your gun' now."
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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