Andrew Swan, Head Asian Equities at BlackRock, is positive for industrial stocks in Asia as China plans to take out capacity.

Mr Swan, how do you currently assess the situation in Asian markets?
The last five years were tough. There were no returns and a lot of volatility. In the last six months it got even worse as problems in China were magnified. This was not only a result of the situation in China, but also an effect of the policy of the Fed. It is still underestimated by many people how important the Fed is for Emerging Markets.

 Andrew Swan, Head Asian Equities at Blackrock Source: BlackRockWhat kind of effect does the Fed have?
The expectation of higher US interest rates had been putting pressure on liquidity and currencies in emerging markets. This happened at a time when the growth drivers for Asia were running out of steam. The model of the past fueled by cheap labor, fixed asset investments and manufacturing growth has run its course. These two factors – US monetary policy and the end of the old growth model – were causing the further downturn in the economy and in the equity markets.

What is the further outlook?
Investors have been very defensively positioned thinking that China will collapse under the burden of its problems. In January we observed a crescendo around these fears. But this crescendo led to a significant change in global monetary policy. And as the Fed seems to be more dovish, the dollar weakened and created a more stable environment for Emerging Market currencies. Since February and March global central bankers are much more aligned in fighting deflation. And deflation is what the market is fearing. Now central banks even seem to encourage inflation.

And liquidity flows back into Emerging Markets?
The inflation trade is about risky stocks, including Asia, Emerging Markets, Materials and Industrials. All the sectors which investors had been shunning. Everyone believes that this is very tactical and sentiment-driven. But I think this trend will persist longer than what most people think. I don’t say that there are no problems, but they are well-documented and the change in monetary policy will be a driver for the Emerging Market asset class. There will also be improvements in growth in China and India. This year will be a better year for Asian growth than what we had for some time.

It is time to overweight to Emerging Market stocks?
Yes, they should outperform Developed Markets in the medium term. But this is subject to policy. If the Fed would decide to be very hawkish about inflation this would be a risk to this scenario. But my sense is that monetary policy will stay dovish which favors Emerging Markets. Also valuations are much more attractive. And that at a time when growth in the USA softened somewhat.

But are these valuations not purely caused by cheap industrial and energy stocks?
Of course you shouldn’t buy the whole index, but look at the individual constituents. But over time the Asian market was clearly mean-reverting. Over the last 50 years the market troughed at a price-to-book ratio of 1 to 1.2. In good times it tends to go up to a PB ratio of almost 3. And now the valuations again bottomed at a PB ratio of around 1.2.

How relevant is the price-to-book ratio if earnings are on a downward trend?
It is true that earnings have been challenged in Asia, but there is some divergence in the market and we are still seeing a fairly benign earnings cycle. Also, new economy, consumer facing and technology stocks generated most of the earnings growth but now old economy sectors look interesting again with valuations depressed and a clear plan to reduce capacity in the system. This should help earnings of the industrial and material companies.

But a reduction of capacity means that not all companies will survive.
We are very careful to select the right companies. The firms which are cost leaders with good balance sheets will make a lot more money. These companies will have more pricing power due to less competition. A decade ago these sectors benefitted from volume growth. This is not coming back. Now it is not about increasing demand. That is why you have to make sure you pick the right horse instead on the whole sector. Korean steel companies might benefit from the capacity reduction in China whilst Chinese steel companies might be risky as they will be asked to merge.

Are companies in Asia prepared that the old growth rates are not coming back?
There is an adjustment process. Companies less look on market share, but they try to improve margins. This is now evident in the numbers. The capital expenditure growth slowed down compared to GDP. And this ratio is inversely correlated with profit margins: when capacity growths fast, margins were normally falling. The outlook for margins for the next couple of years is better than we had seen in the last years.

You mentioned that you favor technology companies. Are they also based in China?
There have been some fantastic investments in the internet space. Also health care companies are attractive opportunities. The backdrop is that the Chinese government has a lot of policies in place to move companies up the technology curve. An enormous amount of money has gone into increasing the penetration, the speed, and the quality of technology and online services in China. This is in contrast to a place like India which has probably the same potential but is six years behind because it lacks a coordinated approach and the infrastructure.

So technology companies are not only copy-cats?
In many ways they are leading the world. One example is shifting financial services online and building business around it. There is an internet company which uses social media data to create their own credit-scoring systems. In thirty seconds you can get a pre-approved consumer loan into your bank account. The online companies are disintermediating the banks in many ways. This sector grows very quickly and is uniquely Chinese.

On the other side we hear bad news about big Chinese banks. What is your opinion on them?
We are negative on the banks. We haven’t played our reflation trade through the banks. We played it by investing in energy, materials and consumer discretionary stocks. The banks start to pay a price for the excess of the past. Bad debts are going up and margins are coming under pressure. But banks might be late-cycle. If the recovery will sustain for some time, the banks might benefit from that. Also the government plans to reduce the debt overhang in the banking system. This is something to watch over the next 12 months.

What is your position on the Korean market?
Overall the market is cheap because there is low growth and low returns. But products of a lot of Korean companies are dependent on Emerging Markets. If there is a recovery in Emerging Markets, the Korean market could do quite well. There have been parts of market where it was very lucrative to invest in, but less so on an index level. Companies could benefit from the consumer in China. There are strong aspirational brands from Korea which were doing really well, for example in the cosmetic industry. Going forward there is still growth there.

What is your favorite market in Asia?
India looks very strong in terms of growth. But you need to be selective in what you own in India. There are very expensive parts of the market. We favor stocks which are domestic cyclicals instead of domestic defensives. Many investors were focused on defensive stocks. But they are expensive in a time when growth looks to pick up.

What sectors in India do you favor?
We overweight companies in marketing and services, financials, and utilities. In developed markets utilities would not count as cyclicals, but in India they are. There is large volatility in earnings driven by the demand side and challenges in passing on costs. We also invest in expanding electricity capacity in India. This is a big opportunity as there are more than 200 Million Indians who don’t have power. The government under Prime Minister Narendra Modi has a plan to connect more people to electricity and make it more reliable. This will generate more growth and bring in more foreign investments.

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