Price-to-book ratios for Asian equities are well below the long-term average, even after January's bounceback in valuations.
Several factors are making Asian stocks increasingly compelling right now. In my opinion, these indicate we are potentially nearing a sweet spot in terms of company earnings outlooks, macro improvements and current valuations, and here is why:
Improvements in earnings revisions
Firstly, the latest earnings revision ratio for Asia ex-Japan has notably bounced, with analysts downgrading at a slower pace. Why is this significant?
It means that while earnings estimates are still falling (reflecting a still softer economic backdrop), the rate of downward revisions to estimates is easing, indicating that earning expectations could be in the early stages of a trough. This improvement in the earnings revision ratio has actually happened sooner than expected – I had originally envisaged this for the end of the first quarter 2019 – and for me this is now a potential buying signal.
Chinese stimulus kicks in
Secondly, we have recently witnessed a number of significantly positive stimulus measures from the Chinese authorities. The China Securities Regulatory Commission appears to be loosening its control on margin financing by giving up the requirement of enforced liquidation when coverage ratios (stock value/margin loans) drop below 130%. This is a positive move – allowing for greater market inflows – but on its own, not super-bullish.
However, it comes after all the other measures we’ve seen in recent weeks -- for instance, the cutting of the reserve requirement ratio for banks, and perhaps most impactfully, the National Development and Reform Commission announcing a stimulus policy to promote domestic consumption. In combination, it is hard not to interpret these moves positively.
Finally, there’s no denying that the US Federal Reserve has become increasingly dovish. This suggests to me that the risks of a resumption of a strong dollar trade (which generally causes problems for Asian and emerging markets) are diminishing rapidly into 2019.
A valuation story
So, what about valuations? This is where the current environment becomes contextually very compelling.
The yellow line in the chart below (showing the MSCI AC Asia ex Japan index¹) is the trailing 12 months price-to-book² (p/b) ratio for the market. The dotted red line is the 10-year mean p/b ratio and the dotted brown lines are +/- 1 standard deviations. This is telling us that, relative to history, the market is cheap.
Can the market get cheaper? It has certainly been lower than today’s level – for a while in 2015/16 when the Chinese A-share market sell-off pulled the rest of the region down, and during the Global Financial Crisis – but otherwise, current prices are historically at a very attractive entry point.
This top-down market view is further backed-up when we look at Tobin’s Q (that is, the ratio of Enterprise Value/Total Assets). Although, no longer more than one standard deviation below, it is below its long-term average. In other words, showing the market is currently undervalued.
Source: Martin Currie and Factset, 1 February 2019
The current macro picture is still less than rosy, with corporations still producing poor earnings. However, in my experience, these kinds of conditions create exactly the kind of environment where we start to think the markets look very interesting. Obviously, we cannot say for sure that the elements above will continue to improve and that we have hit the bottom in terms of the market. However, the above tells me that if these factors persist, the absolute return from an investment in Asia equities should be positive, perhaps quite meaningfully so. In my view, Asian stocks are becoming increasingly compelling and it is interesting that we have three factors looking more favourable at the same time.
¹ The MSCI Asia Ex-Japan Index covers the performance of 944 companies predominanly in China, South Korea, Taiwan, Hong Kong and India.
² The difference between the market price of all a company's shares (price) and the net value of a company's assets (book) is the Price to Book ratio.