In recent months, markets have appeared to be de-linking Asia and the U.S. to an extent. And that is not too far removed from the rhetoric of recently elected President Donald Trump. He has said, “Our companies can’t compete with them now because our currency is too strong. And it’s killing us.”

Agree or not with the analytical framework behind these words, this is a strong sentiment that seems pervasive in the new U.S. administration. To those that focus just on the past five years, it seems a bizarre thing to say—U.S. company results have outperformed Asia over that time period. But is that the true trend or just a short-term blip? To put things in context, let us look at the long term.

Is the short-term trend the long-term reality?

The story is the same when we look at dividends per share—superior long-term growth; inferior short-term growth. However, today investors are paying more attention to the short term than the long term: backward-looking price-to-earnings ratios in the U.S. are at about 24X versus 18.7X for Asia ex Japan as of mid-February, according to FactSet Market Aggregates. I look at backward-looking ratios because that shows how people are forecasting growth compared to where we know we are now. In other words, investors are allocating their money as if the short-term trend is now the long-term reality. Let me put this another way, for emphasis, when you account for the fact that a company’s value is largely created in the long term, investors believe earnings and dividends in the U.S. will outgrow Asia over the long run and this will translate into better returns for the U.S. over the long term. Is this a likely outcome?

I say no. I believe it is quite unlikely.

My argument runs from economic growth to profit growth and from returns on capital to valuation. First, let’s consider GDP growth. In Figure 4, you can see that even Asia’s wealthier nations (Singapore, Japan, Hong Kong and South Korea) tend to have a high savings rate. India and Indonesia, often thought of as savings constrained due to their current account deficits, also currently save about 32% of GDP.

Asia can still invest productively to grow its capital stock and seek efficiencies from reform and innovation. Indeed, Chinese President Xi Jinping set the tone with his comments at Davos: “We should develop a dynamic, innovation-driven growth model.”

Second, let’s look at GDP growth‘s relationship to profit growth. It should not be surprising that the share of profits in GDP is relatively stable over longer periods of time. Yes, it fluctuates, but there are natural boundaries as to how far it can go. Thus, over the long term, faster nominal GDP growth should result in faster profit growth. In Asia, it depends how you measure it, but Asia ex Japan’s nominal GDP (using the same year-end weights as the FactSet Aggregate Market index) grew at about 8.2% compound annual growth rate between December 2001 and December 2016, according to IMF figures. That seems reasonable, for the unadjusted IMF regional groupings performed in the same ballpark (Asia and Pacific 8.2%; East Asia 7.7%; South Asia 10.7%; Southeast Asia 9.7%). Profit growth in the FactSet Aggregate Index, in terms of earnings per share, was 9.6%. But in any year-to-year comparison, the correlation was only 0.75. And whereas it is true that accelerating nominal U.S. dollar GDP growth is usually associated with positive profit growth, the mere fact of strong growth in any one year does not guarantee strong profit growth in that same year.

The key learning from this is that you are not going to get much useful information from looking at year-to-year nominal GDP growth, but if you are willing to look out over a longer time period, it is indeed a useful guide as to future profit growth. And here, according to our methodology and IMF forecasts, we should expect nominal U.S. dollar GDP growth of 7.5% to 10% over the next three to five years. That range— plus or minus 5% on the lower bound for the sake of factoring in risk (so 2.5% to 12.5%)—would seem to set a sensible range for four-year profit growth in Asia’s listed companies, given IMF forecasts. I think the midpoint, 7.5% is achievable. Now that looks really quite decent compared to the U.S., where nominal GDP growth can be reasonably expected to muster 3% to 4% and where the outlook for corporate profits is likely to be below that rate. Why? Because corporate profits over the last decade have been at levels of GDP not seen since the 1950s—there just isn’t that much more juice to squeeze out of that particular lemon. We are often told this is a global phenomenon. Well, no, not exactly. We do see it in many countries but not, for example, in many Asian countries where the picture is markedly different. According to the Asia Productivity Organisation (APO), labor’s share of income in China has risen from 47% to 55% from 1970–2014; for Asia as a whole, it is a similar story.

This seems right. It tallies up with listed-company level data. As wages have continued to rise, particularly in light of recently rising minimum wages, without offsetting productivity gains of the same magnitude, corporate profits have been squeezed. Returns on equity in listed companies have been declining since 2007 to 2008, when the labor share of income in China troughed. I think it likely that this trend will either reverse or at the very least be less severe in coming years, allowing more of that GDP growth to accrue to capitalists than otherwise would have been the case. I am confident, therefore, that earnings per share growth in Asia will likely be much closer to nominal GDP growth than it is has been in recent years. And is a more protectionist U.S.A. likely to reverse this? I doubt it. For if the U.S. is to abandon its strong dollar policy—as evidenced by the president’s comments—and is determined to compete with Asian labor costs by using devaluation, then surely wouldn’t the Asian capitalist benefit from cheaper labor costs at home? Margins may at least stabilize, if not rise, and capital’s share of income will likely rise at least in line with GDP growth.

In my view, future profit growth will likely be superior in Asia.

 

 

 

 

 

 

 

By Robert Horrocks PhD, Chief Investment Officer, Matthews Asia. Click here for the first part of this article.

Enterprise value to Earnings Before Interest and Tax (EV/EBIT) is a measurement to whether a share in a company is cheap or expensive, relative to competing firms or the wider market.

Price-to-Earnings Ratio (P/E Ratio) is a valuation ratio of a company’s current share price compared to its per-share earnings.

Return on Equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested, and is calculated as net income divided by shareholder’s equity.

Return on Invested Capital (ROIC) is a calculation used to assess a company’s efficiency at allocating the capital under its control to profitable investments. The return on invested capital measure gives a sense of how well a company is using its money to generate returns.


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