Nick Scott is BlackRock's CIO for Asian equities. Based in Hong Kong, he is responsible for building BlackRock's Asian investment platform and capabilities. Before joining BlackRock in January 2007, he was CEO and CIO of Prudential Asset Management Hong Kong, where he was responsible for overall business in Hong Kong and investment business in Asia.
Prior to re-locating to Asia in April 2000, he was the head of Asia-Pacific equities in London at M&G Investment Management. He also previously worked for Morgan Stanley International and UBS in London, covering equity derivatives and US equities, respectively.
He shares with AsianInvestor his views of Asian equities under the current environment, as well as his outlook for the next 12 months.
Looking at a one-year period, or even beyond that, what is your outlook for Asian equities?
Scott: The mid- to long-term outlook for Asia remains very attractive. The shift in Asian economies, from an export-led economic growth model to a more balanced consumption-led growth model has not faltered during the financial turmoil of the past 12 months. If anything it could accelerate as Asia realises that Western consumption could be a weaker source of demand for Asian exports going forward. This fundamental shift is likely to play out for years into the future.
Structural return on equity and earnings growth potential remains higher in Asia than in the world's developed markets. India and China continue to grow and assume an ever-increasing importance in the global economy. Over half of the world's population lives in this region and they are growing richer at a remarkable rate. So while the short-term outlook remains volatile, the longer term potential remains strong and attractive.
What are the biggest opportunities that you see in the coming 12 months?
The global economy has not yet recovered to a healthy state. The rally in March and April is based upon investor relief that things may not be as bad as was predicted, rather than concrete evidence that the worst is over and a recovery is imminent.
However, at some point consumption in the US and Europe will normalise and stop acting as a drag on growth for Asian economies. At that point, there will be significant opportunities in the export-driven markets of Korea and Taiwan, as well as in China's export sector. Markets tend to anticipate earnings recovery and we may see this begin to occur in the next 12 months.
The strengthening links between China and Taiwan may also throw up some interesting opportunities as mainland companies acquire stakes across the Strait.
We are also keeping a close eye on India. The economy has cooled as foreign funding has dried up, but it has some insulation from the collapse in global demand. The key factor to watch is politics -- the outcome of the elections is still unclear.
What do you think of Asian equities valuations at the moment?
The recent rally has returned valuations from bargain levels in March to approaching mid-cycle valuations. Certain sectors are already discounting an economic recovery which is premature given where we are in the economic cycle but others sectors are still cheap relative to history. We are still managing to find good companies at very attractive valuations.
What are the biggest challenges that you expect to face?
Asian equities are currently benefiting from a recovery in investor sentiment and the return of funds to the equity market. Any blow to confidence could see investors withdraw from the market again, leading to more volatility.
The global environment remains challenging for Asian exports. Sustained recovery will not be possible until we see rejuvenated consumer demand in the US and Europe and this still appears some way off. At the moment, inventory restocking is providing some support for earnings, however once this dissipates, we may find that true end demand has still not recovered. This could hamper the recovery in profit growth, see weaker quarterly results and result in a blow to investor sentiment.
At the moment, China's resilience is also providing support to the market. Should the momentum in China's recovery start to falter, we could see a return to risk aversion among investors.
Fundamentally, we believe that the world's economy will recover and that Asian economies will be among the leaders in this recovery. Hence the growth potential of Asia is worth the shorter-term risks
Has the global financial crisis and its impact played out the way you thought it would?
The global financial crisis has proved that Asia has not fully decoupled from the developed world. Despite the fact that banks in the region had relatively little exposure to the toxic assets plaguing the US and European systems, Asian markets remained highly correlated to those in the West.
After the markets had collapsed in October, we believed that earnings expectations in Asia were still too high and that the market was underestimating the effect that collapsing US demand would have on this region. At that point, we thought that short-term earnings would disappoint the market and, ultimately, lead to the collapse in sentiment required before a sustained equity recovery could take place. This disappointment and collapse took place in the first quarter of 2009, culminating in the market re-testing its lows in early March. As a result, there is a strong chance that we have seen the market's bottom. That is not to say that we are now in a meaningful recovery -- there is still plenty of scope for further disappointments which can drive the market down again.
How has your view of Asian equities changed, if at all, since the end of 2008 when investor sentiment was generally gloomier?
The picture for Asian equities is certainly brighter now than was the case at the end of 2008. The major change is the rebound in investor sentiment and the increasing global liquidity that is flowing into Asian markets. In the interim, investor sentiment has collapsed and earnings expectations have become far more realistic, which was a necessary precondition for recovery in the markets.
There are significant improvements in the outlook for Asian equities. Most Asian currencies operate a full or partial peg to the US dollar. Low interest rates and quantitative easing in the US provides a classic reflationary stimulus to Asian economies and equity markets. There are strong indications that China's stimulus package has gained traction and has succeeded in offsetting at least some of the effects of the collapse in export demand.
However we still believe, as we did in December 2008, that there is the potential for short-term volatility in the equity markets. Industrial profitability will remain subdued until Western consumer demand recovers and this leaves room for further disappointments.
Have you made any significant changes to your asset allocation in terms of markets or sectors in the past few months, whether because of the crisis, the swine flu, or other reasons?
Over the past few months we have reduced our weighting in China. We were overweight in late 2008 due to its potential to offset slowing demand through its considerable financial reserves. This scenario has played out and Chinese equities have done well. We have reduced our weighting as sentiment has become increasingly bullish over China. Although the stimulus has succeeded in offsetting some of the export collapse, reduced industrial profitability still leaves the potential for disappointments in China in the near term.
We have reduced our underweights in Taiwan and Korea over the same period. We were underweight both countries due to a grim outlook for their export-dependent economies but are now neutral on Taiwan and much less underweight Korea. We have been focused on identifying oversold market leaders in both markets, as well as opportunities to benefit from domestic consumption. The returns from both markets have also been boosted by appreciating currencies.
Generally, the manager has been reducing the fund's defensive bias since the last quarter of 2008, using the market's weakness to identify strong companies which have been oversold as sentiment collapsed.
What are your favoured markets in Asia?
There are many pockets of strength in Asia. We like the Chinese consumer sector, where retail sales remain robust and the longer term trend of increasing consumer wealth will benefit consumer discretionary stocks in China. We also like Singaporean banks, which we believe have been oversold with Western financials but share almost none of the problems that US or European banks have. In Hong Kong, the property market is showing signs of stabilisation early than expected, which is also providing opportunities. We are still overweight China, although this has been decreasing as we have redeployed funds to Korea and Taiwan. We remain underweight the latter two, but strengthening currencies and a rebound in global investor sentiment has seen improving returns from both markets.
What markets are you bearish over?
We are underweight Malaysia, where attractive opportunities are few, and also in India. While the Indian market enjoys a measure of insularity from the collapse in Western consumption, the outcome of the current elections remains unclear and is providing an overhang that discourages investment in the short term.
Many fund managers are very bullish on China, citing reasons that include its Rmb4 trillion stimulus package. Do you believe this hugely positive outlook on China shares is well-deserved?
There is no doubt that China's economy is strong relative to developed market economies. Strong growth in bank lending, a boom in fixed-asset investment and resilient consumption are painting an attractive picture and encouraging investment in the equity market.
However, this must be tempered with a note of caution. The year-on-year trends in China's economy are clouded somewhat by the base effect of last year's snowstorms and the earthquake in Sichuan. In addition bank lending, while enormous, has been very short-term. Ultimately, industrial profitability in the export sector is likely to contract and disappoint until there are signs of sustained recovery, beyond the current inventory re-stocking, in Western consumer markets. This still seems to be some way off.
Given this, we remain focused on opportunities in Chinese domestic consumption and eschew the exporting industrials. Chinese consumption has shown little sign of slowing substantially and remains particularly strong at the high-end. China's continued strength is a bright spot in the global economy and is providing numerous investment opportunities.
Property remains the key swing factor and the next three to six months are crucial. This market is likely to recover before the export market. If the current wave of transaction growth remains sustainable over the next 3-6 months, it may signal growth in property investment, which typically lags growth in transactions by 6-10 months.
In your case, how do you seek exposure to Chinese companies? For example, do you invest mainly in red chips or H shares, or do you invest directly in mainland China shares through a QFII fund?
We invest primarily through H-shares and red chips and Chinese stocks listed in Singapore and the US. Our BGF China fund also makes uses of A-share exposure through P-Notes. We also invest in indirect beneficiaries of a Chinese recovery e.g. resources stocks in Australia.
Which sectors do you expect to outperform in the next 12 months?
Following a good run for defensive sectors, it could be the more cyclical industries which outperform over the next year as the markets anticipate a broader recovery in economic activity. Shares of Asian financial stocks which were particularly affected by the fall-out from Western financial turmoil could perform better in the coming year. The outlook for demand in Western markets is still very unclear and there is still a good possibility of further disappointments later in 2009. We therefore prefer the consumer discretionary and consumer staples sectors, playing on Asian consumption which is well supported by growing incomes and low domestic interest rates.