(Nov 13): James Alexander, global head of multi-asset, Nikko Asset Management Asia, and Robert Samson, senior portfolio manager, multi-asset, Nikko AM, were game for the question: If you were given US$500,000 ($682,000) and had two investment choices — gold or bitcoin — what would it be? Both were unequivocal that the choice was unlikely to be bitcoin.

“The risk is to the downside. Where is the intrinsic value of bitcoin?” Samson asks. “If your computer boils up, if there is an electromagnetic pulse and all the bitcoins got destroyed, the intrinsic value is not there.”

Physical gold has been a medium of exchange since the beginning of time. Now, it is back in demand as part of the de-dollarisation process. China is buying gold, and China affects us all. In the next 20 years, how the Chinese live, work and consume is likely to be the focus for all investors. For one, the renminbi is increasingly used in trade and investment flows and as foreign exchange reserves of about 50 central banks. This year, the European Central Bank (ECB)invested €500 million ($791 million) of its reserves in renminbi-denominated assets.

In 2014, Russia and China signed two 30-year contracts for the sale of Russian gas to China. The contracts specified that the exchange would be done in RMB and Russian roubles, and not in US dollars. Founded in 2002, the Shanghai Gold Exchange officially opened for international members last year. It is a real gold exchange in that it delivers gold bullion. Both Russia and China have been buying gold as part of their foreign currency reserves.

“For China, [gold] is used as a reserve, which will be partly used to back its currency in exchange for oil. There has been a slow decline in dollar reserves on a global scale and some of that is going into gold,” Samson says. To make RMB-denominated oil contracts more appealing, China allows them to be convertible to gold on the Shanghai Exchange. “The Chinese have come up with a new index and they’re making various deals with Russia to settle payment for oil in RMB, but convertible immediately on the Shanghai Exchange to gold,” Samson says.

The move is reminiscent of the deal between the US and Saudi Arabia in the 1970s after the US dollar came off the gold standard in 1973, Samson suggests. The US and Saudi Arabia agreed to standardise oil prices in US dollars, giving rise to the petrodollar system and the US dollar as a reserve currency. “Now, as various countries are trying to trade that oil for something other than dollars, that’s a risk to the dollar, and you need less dollar reserves to pay for oil,” Samson cautions.

Demand from China has already changed the complexion of funds and indices in Asia. “Our Asia equities theme is about the new China and New Economy plays. It’s not limited to China. The benefactors of China’s growth are the entire supply chain, which is Asia, and even Japan is connected to the supply chain in China,” Alexander says.

China, the rise of the middle class across Asia and changing consumption habits are all a related theme. Urban Chinese are tech-savvy and connected. Payments and settlements are done digitally, with AliPay and WePay, which are units within Alibaba Group Holding and Tencent Holdings. AliPay is gradually expanding across Southeast Asia. Baidu, the equivalent of China’s Google, is reported to have 80% of China’s mobile search market. Google, which set up shop in China in 2006, has just 1% after it effectively shut down its operations, following a 2010 cyberattack from within the country.

In a recent study, The Brookings Institute says the largest growth of middle-class consumers is likely to be in Asia. According to the study, there were 3.2 billion people in the middle class as at end-2016. In two years, a majority of the world’s population, for the first time ever, will live in middle-class or rich households, the report states. About 140 million are joining the middle class annually and this number could rise to 170 million in five years, it adds. Of the more than 700 million people expected to enter the middle class over the next five years, 90% will live in Asia and consume an additional US$8 trillion a year.

Proxies for middle class
“Demand for smartphones in China is 2½ times that of the US. We are focused on Taiwan and Korea for the tech cycle, for chips that drive smartphones, cloud computing and the internet of things,” Samson says. In September and October, there was a selloff in Apple’s Taiwanese supplier Foxconn Technology Co because of disappointing sales of iPhone 8 and production issues for iPhone X. The stock is now in a recovery phase, following a strong showing for iPhone X. South Korea and Taiwan are beneficiaries of technology plays.

Already, 40% of the gains in emerging markets have been from tech plays. “Clearly, emerging markets are not as cheap as they were in January 2016, but they’re not expensive,” Samson says, adding that earnings growth in Asia continues to support valuations.

According to Nikko AM’s latest report, valuations for Asian equities are at a 14 times forward price-to-earnings ratio (PER), and 1.6 times forward price-to-book. Despite Asia’s outperformance year-to-date, the MSCI AC World index still trades at 17.5 times forward PER and 2.3 times forward price-to-book.

Meanwhile, Chinese growth is rebounding. “China appears to have found the right balance. It does need reform but it also needs growth,” Samson says. Some of the concerns were in relation to property measures introduced to tame runaway prices. “People were worried about the property market. There has been selective tightening that has affected Tier-1 and -2 cities, but Tier-3 and -4 cities are still growing. That part of the China engine so far is intact,” he says, adding that Chinese credit growth remained at 14% in 3Q.

China’s equity market, represented by the MSCI China Index, has been the best-performing major market globally this year; it has rallied close to 50%, driven by strong macro data and earnings growth. The MSCI China Index is trading at a 12-month forward PER of 13.9 times, a 25% premium to its 10-year historical average.

“Chinese equity valuations look stretched compared with history, which has led to a cautionary downgrade. However, comparing market valuations with history can be tricky, particularly in the case of China, where significant sector weight changes make such valuations less comparable,” Nikko AM says in a recent report. Chinese New Economy stocks — which include the internet, tourism, healthcare, electric vehicles, cloud computing, Internet of Things and semiconductors — are garnering a greater weight in market indices and thus can stay overvalued for long periods. The technology sector’s weight in MSCI China has moved from just 1.25% in 2007 to 40% today. Financials, on the other hand, have fallen from 44% to 22% in the same period.

In addition, the Chinese BATs — Baidu, Alibaba and Tencent — are as famous as the US FANGs (Facebook, Amazon.com, Netflix and Google). Interestingly, earnings growth for the BATs is much higher than the broad market.

Latin America provides countercyclical support
“As a multi-asset team, we’re more focused on regions and how to get exposure in various asset classes within that region,” Alexander says. Multiasset class investments increase the diversification of an overall portfolio by distributing investments throughout several classes, which reduces risk. EM portfolios comprise equities, bonds and a small portion of gold. A sub-theme within EM is a recovery in Latin America.

While developed market bonds are likely to underperform as the US Federal Reserve and ECB start to tighten monetary policy, the cycle in Latin America is different.

“Since the beginning of 2016, currencies [in the region] have stabilised as inflation has come off, and there has been a huge amount of rate cuts. When they cut rates, it supports bonds. So, within each country, you’re thinking about the cycle as well,” Samson says. “You get a nice real yield that is positive, whereas real yields continue to remain negative in most developed markets. That, coupled with rate cuts and potential yield compression, makes for a good investment. You have the equity portion for growth and you follow different cycles around the world to balance growth against yield and potential for rate compression.”

When rates were low in developed markets, Latin America was adjusting as inflation rose, currencies weakened and interest rates surged. Now, after nine years of quantitave easing, the Fed is starting to tighten monetary policy. In addition to raising the federal funds rate (FFR) (equivalent to an overnight interbank rate) twice this year, in March and June, the Fed started reducing its balance sheet in October. The plan is to reduce the balance sheet by up to US$50 billion a month over 12 months, starting with US$10 billion last month. At this rate, the Fed’s balance sheet would drop to around US$2.5 trillion by 2020.

“The Fed set a formula whereby it only reinvests the excess over a cap of US$10 billion a quarter, and then the cap increases by US$10 billion each quarter until it reaches US$50 billion a month,” Alexander says. The Fed’s holdings of government bonds and mortgage-related securities rose from US$900 billion in 2008 to US$4.5 trillion as at Septem ber. The Federal Open Market Committee is widely expected to raise the FFR to 1.5% in December. On Dec 14, 2016, the FFR stood at just 0.75%.

If the Fed picks up the rate of interest rate hikes while reducing the balance sheet, this, coupled with the ECB’s tapering next year, could have an impact on the “liquidity quotient” in emerging markets, Samson says.

Moreover, these tighter monetary conditions come at a time when the US market is extremely overvalued. “The [US] market has got expensive. From our modelling, it’s the most expensive market globally,” Samson cautions.