From an investment perspective, it’s easy to adopt a sanguine view of Asia. The region’s growth rate—expected to hit 5.1% this year¹—continues to incite envy from its peers in the developed world. Equally significant is the fact that the continent occupies the quality end of the emerging-market (EM) universe, making it more appealing to investors. However, that’s not to say that the region is immune from the global economic slowdown.

In our view, the economic downturn in Asia has yet to hit a bottom. Although global risk sentiment has improved in recent weeks, stubbornly low economic growth and low inflation leave markets vulnerable to a reversal in sentiment. We expect a prolonged bottoming-out process and believe subsequent growth will be “L-shaped.”

As the world’s growth engine, the shape of Asia’s recovery has enormous relevance to investors. There are two key reasons why we believe that an L-shaped growth path looks most likely: first, there are numerous headwinds to growth; and second, the region’s governments’ ability to revive growth—from a policy perspective—is somewhat constrained. 

Asia’s economic growth is typically tied to the global industrial cycle, which has been dampened as a result of deteriorating business investment, itself a consequence of the uncertainty brought about by the U.S.-China trade war. Fixed asset investment growth in the region has already slowed significantly on a year-on-year basis from 5.1% at the start of 2018 to just half a percent in mid-2019.² Notably, given that the cumulative impact of the trade dispute has yet to be fully reflected in the economic data so far,³ it’s fair to surmise that Asian exports are likely to remain sluggish through 2020. 

China isn’t coming to the rescue

Over the past decade, the global economy has grown accustomed to relying on Chinese stimulus to rekindle growth. Previous slowdowns, most notably in 2008/09 and 2016, saw China unleash huge lending programs to spur construction, reviving the domestic economy and giving the global economy a nice lift along the way. Interestingly, although growth in China has slowed to its lowest level in nearly three decades, policy response to the current downtown has been limited to measures such as tax reforms, cuts to bank reserve requirements, and tweaks to local government bond issuance.

We believe Beijing will have to accept that it might miss its 6% GDP growth target for 2020—a development that would mark a critical turning point in the global growth cycle. Of note, we believe the Chinese government’s restraint can be traced back to how previous rounds of credit-fueled stimulus aggravated problems in the financials sector. Given the authorities’ stated preference to avoid fueling financial instability, the scale of any forthcoming stimulus will likely be limited in scope and insufficient to reflate the global economy. 

Weakness in manufacturing sectors as a result of trade uncertainty is weighing on domestic demand

On a year-on-year basis, growth in private consumption demand growth has slowed significantly in the last 18 months—from 5.8% in January 2018 to 4.1% in June 2019.2 On balance, we’re inclined to believe that the risk is for more pronounced weakness in the months ahead. 

Inventories are at risk of deeper correction cycle

Manufacturing inventory ratios in Thailand, Taiwan, and South Korea remain at multi-year highs⁴—where we’re concerned this is a sign that the inventory correction cycle could have further to run.

Idiosyncratic risk factors are surfacing

Geography-specific factors are weighing on domestic demand. The ongoing social unrest in Hong Kong, which contributed to tipping the territory into a technical recession in the third quarter, is one such example. Similarly, financial stability concerns in India stemming from the prolonged financial stress among rural households are also on the rise—a credit crunch among nonbank financial institutions have also increased the probability of a more entrenched slowdown in India. These are all issues that investors should monitor in the year ahead. 

In our view, the policy space within which global central banks can maneuver to support growth is constrained by the already low level of interest rates. As monetary policy reaches its natural limits, the focus is shifting increasingly toward fiscal policy. Asian central banks are in a similar position given that policy rates in many countries are already at, or near, record lows. This perhaps explains why we’ve seen a flurry of announcements on the fiscal front in recent months—corporate tax cuts in India and Thailand, labor law reforms in Indonesia that are aimed at boosting investment, and China’s decision to bring forward special purpose bonds for infrastructure spending. Crucially, while the room to ease fiscal policy varies widely across Asia, it’s important to note that much of the region still has fiscal space to implement such measures. However, as budget deficits widen, deficit financing, liquidity, and the government budget constraint become important considerations.  

From a long-term perspective, we believe that the United States and China are engaged in a prolonged strategic decoupling. Consequently, although the current détente appears to be supporting risk appetite, we don’t expect this to be sustainable. In other words, a breakdown in the phased U.S.-China trade talks continues to be a key risk in the year ahead, particularly as the focus of negotiations broadens to include more complex topics.

Issues where both sides aren’t likely to come to an agreement easily come to mind:

• Intellectual property rights protection (specifically in the technology space)
• China’s response to the U.S.-led Blue Dot Network, which is widely seen as a project devised to rival China’s Belt and Road Initiative 
• The recent inclusion of nearly 30 Chinese companies on the U.S. Commerce Department’s “entity list”

These issues are likely to make already difficult negotiations even more delicate. Where markets are concerned, this could mean further weakness in the Chinese yuan and a risk-off environment—particularly in light of slowing Chinese growth. In our view, investors will need to be more discriminating and selective in 2020.

That said, we continue to view Asia as a relatively attractive region from an asset allocation perspective—especially within the EM complex given the region’s narrower output gap, low and steady inflation, and low market volatility. Nonetheless, given the unpredictable nature of U.S.-China trade discussions, quick reversals in risk appetite are unlikely to disappear.

Within Asia, we prefer markets that are less exposed to trade tensions. As U.S. firms scramble to identify alternative products to replace Chinese imports, Malaysia’s likely to feature—in our view—near the top of their list in the short run, with Thailand and the Philippines not far behind. However, if the global manufacturing and supply chain were to shift away from China in a more permanent fashion, then Vietnam is likely to be the main beneficiary over the longer term, followed by Malaysia, Singapore, and India. 

Economic forecasting, although quantitative in nature, isn’t an exact science. As the late professor Rudi Dornbusch once said, “In economics, things take longer to happen than you think they will, then they happen faster than you thought they could.”5 In this instance, our analysis could be undermined by a much sharper than expected depreciation in the U.S. dollar (USD), which could loosen global financial conditions and reboot the global business cycle, and a stimulus package from Beijing that’s large enough to rekindle growth. In our view, these two factors will play an outsized role in determining the shape of the coming Asian recovery.  

1 “Regional economic Outlook,” IMF, October 22, 2019. 2 Bloomberg, November 9, 2019. 3 The United States began imposing tariffs on approximately US$120 billion worth of Chinese imports on September 1. China, in turn, began imposing additional tariffs of up to 10% on some U.S. goods. The effect of these tariffs is not captured in the most recent batch of economic data. 4 Macrobond, November 2019. 5 “A Warning on China Seems Prescient,” New York Times, August 25 2015.