(June 20): While economic fundamentals and earnings results remain strong, the MSCI AC Asia Pacific index has underperformed the MSCI AC World Index year to date. What has happened?

Equity markets plummeted in late January 2018 driven mainly by technical factors, but we were confident that the underlying drivers of corporate earnings remained solid. Global growth prospects were strong even before the new US hefty tax cuts and fiscal stimulus. Combined, we estimate these measures may add as much as one point to US GDP growth.

In an ironic turn of events – as reducing reliance on Chinese imports is a key measure in the Trump Administration to narrow its growing trade deficit – exports from China have surprised to the upside, significantly. Chinese exports doubled consensus estimates year-on-year as of April 2018. At the same time, China’s expected deceleration of economic growth post the 19th Party Congress in 2017 has yet to materialise meaningfully. In the first quarter of 2018, we continued to see strong growth, despite the pace appears to have moderated more recently. In short, we see a disconnect between the economic fundamentals which remain supportive of risk assets, and investor sentiment which sees a deteriorating picture ahead.

Lack of policy visibility, especially US trade policy not just with China, but with close allies such as Mexico, Canada and the European block, has unnerved investors and corporate management teams. The heightened uncertainty has limited upside potential for stocks that would have otherwise risen purely based on fundamentals. If the issue was solely about trade, we are confident that negotiation would resolve it. If, however, we are dealing with something bigger than trade, such as attempts to undermine China’s competitiveness in key areas of the “Made in China 2025” plan, the implications for China’s growth and the region could be significant. We are watching this closely and will adjust the portfolios if necessary.

This year, we have gradually reduced our overweight position in China to a more neutral one, primarily by selling or reducing positions in high tech companies that benefited from government policy but whose future earnings may be at risk (particularly in the internet space). Overall, the portfolios remain positioned for stronger economic growth, based on our reflationary expectation. This has not been working lately due to heightened uncertainty. Fundamentals remain strong, but the risks to the outlook have risen.

We see rising US protectionism as the clearest threat to the near-term growth outlook. Other risks include stronger US dollar and rising US interest rates. EM and Asian currencies have come off their highs from earlier in the year, and equities have underperformed developed market counterparts recently. Higher US interest rates make high-yielding EM and Asian assets relatively less attractive. That, combined with solid US economic data, sent the US dollar to its highest against a basket of currencies since December 2017. A stronger dollar usually spells trouble for EM, in part because it makes servicing external debt more expensive for EM borrowers. Asia, however, is relatively isolated from this because reliance on dollar financing is significantly lower than in other parts of the world.

The pace of deleveraging in China is another factor that has run ahead of our expectations. We believe the government would be deleveraging the economy in a stronger growth environment and have been surprised by how quickly credit growth has slowed amid rising risks to growth. China’s desire to deleverage into a potential slowdown due to causes other than trade policy (and trade risks have also risen) is a concern that may have been priced into markets. We are not seeing this in the economy yet, but there could be a lagged effect from deleveraging that could still come through in the second half of the year.

A big question is whether we are still in the post-crisis environment of slow growth – where deleveraging is a problem – or whether we are in a pre-crisis environment where global growth is strong, fuelled by fiscal spending in the US, tax cuts and infrastructure spending. Thus, an external driver can benefit the Chinese economy via exports. In this case, it makes sense to deleverage and growth is unaffected by it.

We have made marginal adjustments to the portfolios, which remain positioned for our base case of a better growth environment. We maintain overweight positions in energy, materials and financials, which should be early beneficiaries of reflation. Thus far, we have seen physical commodities move up but the equities have yet to follow. For example, the MSCI World Energy Index is not responding to the higher oil price – although company earnings are seeing upward revisions and top-line growth is strong. We see reluctance of share prices to move up as mirroring the belief that the price surge in oil, copper, steel and coal may be short-lived.

Recent signals that oil crude supplies may be boosted by the US and OPEC members in the second half of 2018 rattled the rapid ascent of oil prices this year. Indeed, we may see greater volatility going forward, but the trend and speed of change matter more from an investment standpoint. If oil prices remain in the range of US$60-70 per barrel, energy stocks are cheap. The companies are showing very strong earnings growth and large output revisions, but these have not been reflected in their stock prices. Steel prices and steel margins are at the highest levels in ten years and cement prices are rising, but the equities are not responding to that.

In industrials, we have been increasing our position. There has been a capex strike in Asia for the past 6-7 years. With low capacity utilisation, companies have not seen a need to spend more on plants and equipment. Our view has been that as growth begins to pick up, companies will begin to use high cash balances to reinvest in their businesses. This is what we are seeing. We are coming out of this capex strike, but the positive sentiment of companies has yet to be echoed in the equity markets.

Swan is Head of Asian and Global Emerging Markets Equities at BlackRock