The Tantallon Asia Impact Fund closed 4.11% lower in December 2022, a disappointing month bringing a disappointing year to a close with risk markets having second thoughts again on the global central bankers’ resolve to continue tightening monetary policy even at the risk of a deep recession to restore price stability and central bank credibility.
Hitting the 2022 reset button and looking ahead into the new year, growth in Asia is poised to surprise meaningfully on the upside on the back of China’s reopening, structural and cyclical tailwinds in India and Indonesia, coordinated regional monetary policy easing and support as headline inflation moderates, and as a buffer against recession risks in the US and Europe.
China’s reopening and the apparent volte-face on zero-Covid, the three “red lines” and its wolf-warrior geopolitics, are significant and investible. Over the last few months, we have written at length about the implications of China’s economic and demographic malaise, with policymakers being forced to re-calibrate their antagonistic approach towards private domestic risk capital (in particular, in the property and internet sectors) and global supply chains starting to relocate capacity out of China, worried by the street protests and the backlash from three years of rising unemployment in the 20–40-year-old age bracket in China.
To be clear, China is not “out of the woods” because we believe that (1) the Xi Administration is temporarily walking back on — and not walking away from — their longer-term goals on common prosperity, projecting a more assertive geopolitical presence globally and eventually having full control over the South China Sea; and (2) the risks of further economic disruptions and potential new lockdowns as China reopens are obvious as Covid infections, hospitalisations and mortality rates spike in the absence of domestic “herd immunity” from a more effective vaccination regime.
That said, we are looking to rebuild our exposure to China as we expect peak Covid infection rates over the next four to six weeks following the Lunar New Year travel period. We believe that easing domestic monetary and regulatory policies, a sharp growth revival over the next 18–24 months as private domestic risk capital is unlocked, the reduced risks of sabre-rattling over the South China Sea over the next couple of years, and compelling valuations, will create a very favourable backdrop for Chinese equities to re-rate.
We remain focused on the compelling long-term investment fundamentals underpinning India and South Asia’s demographic dividend, China+1, industrialisation, and sustained domestic demand and consumption patterns. However, in the short term, we are quite mindful of the risks of heightened market volatility and potentially getting whip-sawed by algorithmic and macro traders “switching” out of the outperformance in India and South East Asia into the laggards in China/ HK/Macau.
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The schizophrenic “inflation watch” of the last 12 months may well be yesterday’s news. Global central banks have belatedly responded to persistent and elevated inflationary expectations by starting to sterilise central bank largesse of the last decade.
As global supply chains and energy prices start to “normalise” and as labour markets start to readjust to the realities of slower or negative growth in the developed world, we do expect that moderating inflationary expectations will finally allow global central banks to signal a ‘pause’ in the second half of the year.
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In Asia specifically, as global costpush pressures primarily due to energy prices abate and given benign regional domestic labour market dynamics and China’s economic malaise, we are likely to see regional monetary and industrial policy turn “accommodative” and explicitly growth-supportive into the second half of the year given the risks of a sharp slowdown in exports to the US and Europe.
Ukraine war a pressure point What are our nagging concerns at this point?
The war in Ukraine is a big worry. Given the hardliners in Russia becoming even more assertive and the reaffirmation of US/EU support for Ukraine, it is difficult to project a speedy resolution of the war. We remain quite concerned over the risk of escalating and irrational military action by the Kremlin.
We remain concerned over the implications for energy prices and inflationary expectations globally — despite the recent pullback in crude and natural gas prices reflecting the slight thaw in Saudi-US relations (encouraging the prospects of a more benign Opec going forward), the first signs of demand destruction in Europe and the US, a recovery in US shale production, and a moderate European winter thus far. Our long-held view stands that the marginal cost of shale production of US$60–US$65/barrel ought to represent the longer-term price range for crude.
We are also closely tracking the shortfall in agri-commodity and fertiliser production in Russia and Ukraine, which does have negative implications for global food prices and inflationary expectations, and the mounting risks of European de-industrialisation given the dependence on high-cost gas.
US yield curve inversion
The US yield curve inversion and can the Fed possibly “finesse” a soft landing?
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The negative spread between 10- year/two-year US Treasuries and the even more dramatic inversion between 10-year/three-month US Treasuries, is troubling.
The yield curve inversion would seem to be looking through the current Goldilocks data in real-time (receding headline inflation, low jobless claims, and jobs and GDP continuing to grow, albeit at a more modest rate).
The inversion would seem to be signalling the rising probability of a US hard landing given that the Fed will likely remain data-driven (“employment is still holding up”), and “committed to hiking rates over 5%” (in response to persistent wage pressures and services inflation), even at the expense of a potentially extended down-turn, and meaningful job losses and demand destruction.
We are likely on the cusp of a recession in the US. In 25 of the prior 26 instances of both ISM (manufacturing and services) reports falling below 50 (as it just did in December), the US economy was either in, or three months removed from recession.
Our view stands that (i) the Fed will (most likely) raise rates by another 100 bp over the next six months, (ii) the US$ is likely to have peaked, supporting strong positive flows into non-US$ risk assets (for the first time, really, since 2009), and (iii) we need to be especially cautious with regards to earnings for the more economically sensitive stocks, and in particular, with regards to companies exporting into the US.
The outlook for Japan and China
Japan remains the wild card. While we are seeing nascent indications of a potential structural “shift” in monetary and military policies, given Japan’s demographic constraints and the potential drag on Japan’s export economy given global recession risks, we are uncertain how the forces of domestic politics and posturing translate to policy action and reforms, and ultimately, set the direction for domestic interest rates and the yen.
The market’s latent uncertainty and lack of conviction on the outlook for rising interest rates, recession, demand destruction, potentially sustained US$ strength, China’s “reopening” and ongoing Covid disruptions, and geopolitics will almost certainly ensure extremely volatile markets over the next few months.
However, as the Fed starts to establish a shift into “neutral”, probably by the second quarter of 2023, we expect (i) the US$ to peak, (ii) valuations to have more appropriately priced-in recession/ earnings risks in the developed markets, and (iii) for markets to start to anticipate global policy easing into 2024 and a growth recovery as China “normalises”.
Growth in Asia to persist
We believe that growth in Asia is poised to surprise meaningfully on the upside on the back of (1) China’s reopening, (2) structural and cyclical tailwinds in India and Indonesia, and (3) more coordinated regional monetary policy easing and policy support as headline inflation moderates, and as a buffer against recession risk in the US and Europe.
China/HK, Korea, Taiwan (and specifically, chemicals, autos, transportation, and select semiconductor and internet stocks), and the Australian commodity stocks are likely to be the obvious beneficiaries, and we are starting to build our exposure to an early-stage cyclical recovery in North Asia.
Despite their outperformance over the past year, India and Asean remain strong convictions given growth-supportive, orthodox monetary policy, strong demographic tailwinds, infrastructure spending to facilitate industrialization and new job creation as global manufacturing intentionally reduces supply chain dependence on China, urbanisation, and sustainable domestic middle-class consumption.
Our core convictions remain, bottom-up, in energy and food security, China+1, industrialisation, domestic consumption and services across India, South Asia and China, urbanisation, and decarbonisation and electrification, where valuations are attractive, and where we have good/improving visibility on structural sector tailwinds, fundamental business moats, and sustained earnings and cash flow growth.