Why the future looks brighter for equity markets in Asia than in US and Europe

The first half of this year saw dismal returns for equity investors. The MSCI World Index was down 20 per cent and many equity indices around the world have fallen into bear market territory. As a region, Asia has fared better than the US and Europe with only the technology-heavy Korean and Taiwanese markets down by more than the global benchmark. In part, this reflects a more balanced macroeconomic backdrop, with Asian economies not suffering as large an inflation shock as elsewhere. It also reflects the particularities of the Chinese economy and how markets there have performed. Last year was not good for Chinese equities but, since April, things have improved. Rising global bond yields and the prospect of slower economic growth has led to a derating of equity markets. This has been most pronounced in the United States, where markets became very expensive due to the easing of both monetary and fiscal policies in 2020. Using estimates of forward earnings (profits) from equity analysts, the price-to-earnings (PE) ratio of the Nasdaq Composite index topped 23 in September 2020 with the S&P500 index being valued at 34 times earnings at the same time. The past year has seen these valuation metrics tumble and the PE ratio is now back to its historical average for both indices. Valuations typically fall when interest rates are rising. Now, it looks as though interest rate expectations have stabilised in the US and Europe. Thus, going forward, what happens to corporate earnings will be important for equity investors. Economists have been busy revising down forecasts for economic growth on the back of tighter monetary policy and the impact of the global energy crisis on real incomes and corporate profit margins. Logically, this should translate into a more difficult environment for corporate profits. Yet, earnings forecasts remain positive. For the companies covered by the MSCI Asia ex-Japan Index, earnings are expected to rise by 10 per cent on average over the next 12 months. For the S&P500, the forecast is for 9 per cent earnings growth, and for Europe it is not much lower. There is clearly a risk that these earnings forecasts will get revised down in the coming months, ushering in another potential drop in global equity markets. The US market is the most vulnerable. Corporate profits boomed during the pandemic recovery period. Current earnings per share for the S&P500 are around 15 per cent above estimated trend levels. Typically, in a recession, the drop in earnings from peak to trough can be at least 20 per cent, and is often more. Outside the energy sector, it is easy to see what could happen to corporate profits, given the rising costs, higher interest rates and slowing revenues. While trying not to be too alarmist, a reversion to trend earnings – even at the current price-to-earnings ratio for the S&P500 – would mean a full reversal, and more, of the recent market rally that has taken the index from a low of 3,666 to 3,900. If the PE ratio were to fall further, the index could drop to below 3,000. Much depends, of course, on whether the US can achieve a soft-landing, as well as what happens to global energy prices and in the Ukraine war. Elsewhere, the picture is less bleak. Earnings growth in the Asia-Pacific has been more stable and expectations for the next year are positive. Furthermore, stocks in the region are less expensive, with a PE ratio of just 10 for the MSCI Asia-Pacific ex-Japan Index. There is less downside to both the level of earnings and the valuations attached to those earnings, which should support Asian equities’ performance in general. The more positive outlook for Asian stocks is supported by the economic outlook for the region. In the US, the debate is turning to how bad the recession may be rather than whether it is coming. In Asia, consensus economic forecasts are for healthy growth in 2023. Inflation is also more moderate, meaning less need for central banks to aggressively raise interest rates. Asia’s gradual Covid-19 recovery means it has less to fear from inflation Over time, earnings drive the total returns for equity investors. Earnings – or profits – are either partly distributed to shareholders as dividends or buy-backs, or retained to invest for further growth. Earnings themselves are intrinsically linked to economic growth and, as a region, Asia remains undervalued, given its positive long-term demographic and social trends that will underpin higher growth rates than in more developed economies. Global equities could remain under pressure for some time but, once sentiment improves, Asia should provide strong returns. Chris Iggo is the chief investment officer for core investments with AXA Investment Managers