After five years of steep earnings downgrades in Asian equities, we are now seeing encouraging signs that this trend is abating. While this might partially be a reset of prior expectations that were unrealistically high (be it in the form of reform potential in India, or the take-off of Chinese internet companies), it has also been a welcome indication that companies are starting to be more disciplined around capital expenditure and returns on equity. Coupled with early signs of a pickup in demand, it makes us more optimistic that we will reach a more balanced supply/demand environment, which should translate to an improved Asian corporates’ pricing power in the long run.
While capacity has been abundant due to over-optimism regarding Asia and in particular China’s growth leading to years of ramp up in capital expenditure, we are starting to see signs of better capital discipline. For the past few years, when China seemed like a growth engine that could not be stopped, companies significantly increased capacity. The dramatic increase in supply outpaced demand, leading to a period of deflation as prices were under pressure and earnings downgraded as a result of margin compression. Coming from such elevated supply, Asian companies spent the recent years reducing capital expenditure. This can be seen through supply side reform and regional industry consolidations in China which is pushing local corporations to focus on margins and returns rather than topline volume growth. With reducing competition and excess capacity, we are starting to see signs of price tension come back into the system helping companies regain pricing power.
On the demand side, as companies lack conviction around future demand, they have held on to cash instead of investing in their businesses despite historically low interest rates. Recently though, we have noticed a turnaround, where Asian corporates have started to reduce their cash through share buybacks and increased dividend payments. We have also been encouraged by early signs of an increase in demand as leading indicators such as cement demand, construction, and property sales have started to pick up.
We think Asia is currently on the cusp of a turning point and that better capital management, more stringent capacity controls and early signs of revival in demand should provide a solid platform for better, more sustainable equity returns in the region.
Bull:
- The pace of earnings downgrades in Asia has been declining as companies are more disciplined around capital expenditure and as we are seeing early signs of a pickup in demand
- A more balanced demand and supply environment offer an attractive buying opportunity for Asian equities
Bear:
- As top line growth resumes, companies and government alike could revert to the bad habits of the past and over expand
- Demand remains weak and requires further supply cuts which would have a negative impact on employment and by extension, consumer trends
Column by Andrew Swan, Head of Asian Equities for the Fundamental Equity division of BlackRock’s Alpha Strategies Group