When I made my first trip to Asia in 1995, it changed the way I thought about the world. Beyond the diverse, rich cultures that countries like China, Indonesia, Vietnam, Thailand, and Malaysia offer, what struck me most about the region then – and still shapes my thinking today – is the explosiveness of its economic growth trajectory.
No doubt, China has clearly been the economic star performer in terms of sheer size during the past few decades, but as Exhibit 1 shows, its trading partners in EM Asia now actually account for 25% of incremental global growth, just behind China itself at 35%. Moreover, while Japan, Australia, and South Korea do not offer outsized growth rates, they are large economies with distinct macroeconomic and societal trends worthy of investor attention, we believe.
So, it should not surprise folks to learn that I was again back in the region with my colleague Frances Lim, looking for clues to stay ‘smart’ on the global macro trends that are helping to shape KKR investments both inside and outside the region. So, what did Frances and I learn during our latest Asian ‘deep dive’ this fall? See below for details, but our primary conclusions are as follows:
Asia’s surging middle class, coupled with strong productivity trends, signal robust structural growth for the foreseeable future. Without question, having the two key components of GDP – labor force growth and productivity – trending so strongly is an important differentiator for the Asian region at a time when many parts of the global economy are facing demographic and/or productivity challenges. Compelling urbanization patterns across the region are helping too. As a result, overall GDP-per-capita in Asia is growing significantly faster than in many other parts of the world. From an investment standpoint, we think that such high levels of strong structural growth across a variety of industries, including consumer financial services, payment processing, education, and healthcare delivery, will be constructive for the trajectory of earnings and multiples in the coming years.
From a cyclical growth perspective, we think that China’s nominal GDP growth has already crashed, which has important and positive implications for the way we view the Asian emerging markets story during the next three to seven years. Contrary to popular opinion, we believe that the earnings power of many Asian companies, including traditional ‘old’ economy sectors, has already troughed and is actually headed higher in coming quarters. For example, in Beijing we consistently heard that supply side reforms as well as increasing demand are boosting corporate profitability. Meanwhile, domestic consumption has accelerated across several Asian economies (including China), helping to drive what we believe is a slower, but sustained period of economic growth. Stronger local Asian currencies – compliments of not only a weaker dollar but also smaller deficits and higher real rates in the region – give us additional confidence that now is the time to be allocating more to EM Asia stories. See below for details, but our EM model, which began to inflect upward in early 2016, is now actually pointing towards the beginning of the ‘mid-cycle’ phase of a long-tailed recovery.
As we detail below, we see Asia as a direct and compelling play on three of our global macro themes: de-conglomeratization, experiences over things, and the illiquidity premium within performing private credit. Not surprisingly, having three of our highest conviction global investment themes playing out strongly across the region underscores our confidence in our macro outlook. Importantly, we think the lens through which we are looking extends across equities and debt, including both private and public securities, and it includes large, fast-growing industries such as healthcare, technology, consumer financial services, wellness, and leisure.
The biggest changes in Asia we see are not only the continued migration up the value-added ‘food chain’ across a variety of domestic industries but also the impact that technology is having on delivery of these higher value-added goods and services. This transition is a big deal, in our view, as it is creating notable winners and losers, particularly among providers that can offer the perception of aspirational value to middle class consumers who increasingly want to upgrade their lifestyles. Importantly, delivery preferences of both goods and services are changing quickly in Asia. Already, the digital payments market in China has surged to $9 trillion in size, up from just $15 billion in 2011 and now 80x greater than that of the United States. Not surprisingly, the impact of this shift in consumer preferences extends far beyond mobile commerce and financial services to include more traditional areas such as logistics, real estate, and transportation. Given the speed and the magnitude of the aforementioned changes, we think that investors need to keep well-informed on the enormity of this transition for both offensive and defensive reasons.
Importantly, though, beyond strong growth in domestic demand stories, we also see more opportunities for allocators of capital to help Asian companies – both in developed and developing markets – expand abroad. Somewhat differentiated, Asian companies are benefitting not only from surging domestic demand for higher value-added services, but also the opportunity to export their offerings abroad through a variety of channels, including M&A, joint-ventures, and de novo efforts. Key industries on which to focus include technology, healthcare, travel, and financials.
To be sure, Asia is not without its macro and geopolitical blemishes. As we describe in more detail below, China is still growing its nominal debt well above the rate of its nominal GDP. At the moment, Frances’ base case forecast is that debt-to-GDP in the country could reach nearly 300% by December 2021 (Exhibit 58). In her bear case, however, if credit growth continues in the mid-teens, then debt-to-GDP could actually reach 300% by 2019. Meanwhile, geopolitical tensions in North Korea continue to escalate, a potential market-disrupting influence to which we believe that investors must pay attention. Finally, global trade, one of the key engines of growth during the past two decades, appears to have slowed notably. Given Asia’s outsized role in this once dynamic area of the global economy, we believe that investors must incorporate the potential for global trade to grow at or below the rate of overall global growth during the next five to seven years.
Without question, our trip gives us great confidence in the region across several parts of our asset allocation framework. In fact, we are actually using this opportunity to increase our non-Japan Asia exposure to an overweight position of nine percent versus a benchmark of seven percent, an increase of two hundred basis points. We fund this by reducing our U.S. equity position to 17% from 19% and a benchmark of 20%. Key markets on which to focus include Indonesia, India, Vietnam, and China. See below for details, but our models increasingly suggest adding exposure to EM, particularly countries with large domestic economies that can withstand any further slowdown in global trade.
Meanwhile, we left Asia feeling more confident about our existing 200 basis point overweight position in Japan. Growth has been positive for six quarters in a row, and equally as important, we now have higher conviction that ongoing shareholder reforms will continue. Meanwhile, we have also gained further confidence that the benefits of the illiquidity premium in Private Credit extend nicely to Asian markets such as India, Indonesia, and Australia. Finally, our work continues to show that the U.S. dollar is in the process of topping, which suggests a much more favorable backdrop for both local debt and equity in the region versus the prior five years.
Overall, we now hold the view that a multi-year run of solid investment opportunities lies ahead. Indeed, with China rebounding off its low, rising GDP-per-capita stories are now working again across the region. In our view, the macro backdrop has not been this positive for these types of stories since China’s nominal GDP first began falling in 2011. Moreover, both long and short investment opportunities linked to Asia’s ‘new economy’ are now exploding, as middle class consumers are dramatically shifting the way they do business across almost every sector we reviewed during our trip. Finally, while growth remains more muted in more mature economies like South Korea, Australia, and Japan, we see both internal and external forces driving CEOs to create more efficient corporate structures, propelling what we believe will be an important wave of M&A activity during the coming quarters. If we are right about the aforementioned trends, then now is the time for multi-asset class investors to be ‘leaning in.’
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Henry H. McVey, is KKR’s Head of Global Macro and Asset Allocation