Kevin BlacklockBy Kelvin Blacklock, Chief Investment Officer, Global Asset Allocation, Eastspring Investments

After the financial crisis of 1997, the Asian and emerging markets materially outperformed the United States. However, since 2010, Asia Pacific ex-Japan has underperformed the US market by around 70%.

The reasons for the de-rating of Asian markets over the past five years are threefold. Firstly, the relative growth differential between Asia and emerging markets and the developed world narrowed, contrary to consensus; secondly, relative profitability (returns) deteriorated; and, thirdly, the valuation starting point for Asia and emerging markets was expensive in 2010.

For investors, a key point is that based on relative profitability and returns, Asia Pacific has been de-rated too aggressively. Relative valuation in the context of trend returns (profits) now favors Asia Pacific relative to the United States. Return on Equity (profitability) for the United States is 14%, compared to 12% for Asia Pacific ex Japan (a 17% premium). However, the US trades at a 75% valuation premium (based on price to book) relative to Asia Pacific.

At Eastspring, we believe it is important to differentiate between “paper tigers” and “golden dragons” as there are considerable differences within the Asia market.

In our portfolios we have a clear preference for North Asian markets - the golden dragons - and are overweight China (Hong Kong-listed), Taiwan, Korea and Japan. The golden dragons offer more valuation upside and leverage both the global cycle (dollar strength) and domestic policy easing.

By contrast, South East Asia, in particular the Philippines are paper tigers. Valuations are relatively expensive and growth assumptions too optimistic. South East Asia is also likely to be more vulnerable to dollar strength, higher US short rates and capital outflow. Historically, valuations in South East Asia have de-rated during US policy tightening cycles.

In China, we are hopeful that a bull market is now underway. Valuations for Hong Kong-listed China equities remain inexpensive at 12 times forward earnings. While trend growth has moderated, real lending rates are high. Therefore, the central bank has capacity to ease monetary conditions and support growth. Reform and liberalization also appear to be well underway. China has opened access to the domestic equity market and taken steps to liberalize and internationalize their currency - a necessary condition for inclusion in the major global indices.

Policy makers also appear to have taken measures to address bad debts in the local government financing vehicles by allowing them to issue municipal bonds and the banks to place those bonds with the central bank.

This policy should reduce the interest cost for local governments and shift the debt burden to the government (via the central bank). China still has considerable excess capacity, excess leverage and weak cash flow in its state owned enterprises. The authorities have taken important steps to address the systemic risk that is likely to contribute to the valuation re-rating of the banking sector and the broader equity market from inexpensive levels.

Following six years of expanding profits and a 215% rally in price itself, US equities will offer less valuation upside or trend returns over the next few years. We recommend investors shift their attention to Asia Pacific markets that are trading at a material discount, adjusted for relative profitability. Within Asia Pacific we favour the golden dragons of North Asia (China, Taiwan, Korea and Japan) rather than the paper tigers in South East Asia, where valuations are more optimistic.