Asset Allocation Q1 2019

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For the Asian region, 2018 has been characterised by investor fears about trade wars between China and the US; by the impact of a rapidly slowing Chinese economy and by the bursting of the tech bubble. In 2019, we expect the global economy to continue to decelerate, with the most difficult quarter likely to be Q1. We anticipate a significant slide in the Renminbi, which will affect earnings everywhere. However, as Asia and the Emerging Markets have already been heavily sold down, we expect them to show relative outperformance versus the US and some developed markets, although we do expect a strong bounce from the UK and
Sterling once the terms of Brexit become certain. Asian governments are traditionally dirigiste and so a significant attempt to boost local economies and stock markets in Q1 2019, led by Beijing is likely. This makes the outlook for markets especially tricky, as we see strongly negative economic and political fundamentals in China at present, coupled with an increasing likelihood of a very sharp and unpredictable rally, maybe of double digit percentage points.

Much of the slowing in China has been self-inflicted and the impact of trade wars has yet to be felt across the wider economy. Consequently, at least some of these effects can be undone or ameliorated. However, Beijing is definitely not able, or indeed willing, to reverse every policy mis-step made in 2018 and this will generate some significant trends and themes in 2019. The log jam engendered by the simultaneous reorganisation of 32 ministries in March does seem to finally be easing and ministers are belatedly pulling together again. Unfortunately, the “help” they are offering is often uncommercial and doing more damage to companies, local governments and the wider economy. Both debt and assets are being securitised in increasing complexity, onshore and offshore, and project partners are pulling back from Belt and Road projects. The need to stimulate will stop Beijing improving the fiscal deficit and pressurise the currency, just when rising US rates have worn away the differential between 5-year bond yields in both countries. Developers are buying less land because they are contending with their own debt problems, high vacancy rates and slowing sales, which is normally key to local government finances. The increasing weight of A shares in regional indices may entice some investors back, but a major outflow from the Renminbi looks inevitable, the only question is when. We expect the State Administration for Foreign Exchange (SAFE) to burn reserves until accounts are struck (for audit) at year end and then let the currency go. With GDP slowing in 2019 to a likely range of 5.5-5.8%, and the current account under pressure from increased purchases of gas and soya, let alone higher tariffs, the currency could drop to 7.60-7.70 to the US Dollar over the full year. The real impact of the trade wars has barely been seen so far, but advance ordering to avoid the increase in tariffs has stolen sales from the habitually weakest quarter of the year, especially for tech, making global earnings downgrades inevitable. China has also kept its most powerful powder dry: to date it has not yet started to sell US debt significantly and nor has it tried to restrict sales of rare earths to the US.

Q1 should be the toughest quarter in 2019, but it is not all negative. The weaker Rmb will stimulate exports – to the rest of the world, if not America and two vast new trade treaties, CPTPP and RCEP, are due to start / be signed respectively in Q1, which will give Asian companies a cushion unavailable to those in Western Developed Markets.

The Indian outlook in 2019 appears similarly tricky. It has the best PMI readings in Asia and upcoming elections should provide a natural stimulus. The negative impact of the rise in sales taxes (GST) in 2017 has finally started to fade and the country is considered less affected by trade wars than others (despite its gross exports to GDP being equal to those of China), but it is the most expensive market in the region and lower oil prices damage India’s largest trading partner, the Middle East, as well as helping the fiscal deficit. Prime Minister Modi’s ability to win another term looks uncertain and the surprise resignation of the Central Bank Governor suggests that the ruling party intend to literally blow the budget, punishing an already weak Rupee. Similar pump priming looks likely to support voters in Thailand, Indonesia and the Philippines in 2019, but all three currencies look more robust.

It is important not to get too bearish about 2019. Markets look tricky, but there are some tremendous opportunities too. There are always some of Asia’s 15,000 stocks performing well, even in the most uncertain of times. India, Indonesia and the Philippines all have very large populations and principally domestic economies. Relations between the two Koreas are warming rapidly and we expect a steady stream of positive news in 2019. The weakness in the domestic economies of South Korea and China’s North Eastern provinces only adds more impetus to rapprochement. Southern Korean companies have the second lowest net debt in the region and MSCI Korea trades at just 0.74x Price to Book. Nothing positive is priced in.

China’s trade woes, wage inflation and tightening authoritarian climate are all pushing companies to relocate around the region in vast numbers and the tight labour situation in Japan is creating a similar diaspora, benefiting ASEAN countries most. Of these, Indonesia is our preferred pick, as it starts to harvest recent structural economic and fiscal reforms and infrastructure improvements. The Philippines should also collect on the tax reforms pushed through in 2016-2017 and substantial inflows of FDI, giving it sustainable GDP growth in excess of 6% in 2019.

We are, of course, concerned about debt everywhere in 2019, but the ability to service it is much better in the Emerging World than in the West. The volume of debt maturities in the Emerging World does begin to jump in 2019, before peaking in 2022, but a similar pattern in the DM world suggests that the US Fed may pause in its normalisation this year.

Valuations are similarly tricky. Although Asian markets have already sold off heavily, taking sentiment to multi-year lows and some stocks are now too cheap, in aggregate many indices rest only at their average Price to Book valuations, despite P/E estimates over 2 standard deviations below their mean. PBV data may be inflated by the rise in debt, but earnings downgrades from trade implications have yet to come.

On balance, we think that when the US Fed pauses in its normalisation of rates, Asian markets are better placed than their Developed market counterparts and already poised to fly. If any kind of trade deal materialises, the rally could be both vast and sustained.

Indonesian Economics

The Indonesian economy remains on course for around 5.2% expansion in GDP in 2018 (the government have just upgraded its target to 5.17%), followed by a slight moderation to around 5.1% in 2019. The PMI readings are still holding in expansionary territory, although they have moderated a little with the recent rate rises.

Despite the rapid depreciation of the currency this year, inflation has remained moderate by Indonesian standards, because BI has consistently raised rates ahead of the curve (and importantly, ahead of the Fed (BI has raised six times this year already)) and fuel prices have been capped. The cap is not expected to be lifted until after the election in April 2019, most probably in Q3, after the formation of the new cabinet in June. When that does happen, new supplies of regionally-produced gas are expected to push down gas prices and if, at that time, oil is high again, users are expected to switch to domestically produced gas in what might in future be a self limiting mechanism. There is upward pressure on core food inflation, as producers like Indofood pass through cost increases in their noodle portfolio. The growing middle class is shifting towards more premium products, which will underpin consumption generally, but price wars are intensifying in basic goods like nappies and carbonated beverages, so CPI, which currently stands at 3.3%, is expected to rise, but remain contained at c 4.5% in 2019. President Jokowi took a considerable risk reinstating fuel subsidies this year and as oil prices briefly rose sharply, the drag on the fiscal and current account deficits pulled down the currency together. Now that oil has collapsed from $86 to $60, the Rupiah is rallying and creating space in the fiscal budget for further economic support.

The collapse in the Rupiah this year has been attributable to three elements: the twin fiscal and current account deficits, the amount of government debt held by foreigners and the amount of corporate debt held in USD. The completion of infrastructure projects, along with a series of reforms and the fall back in oil are expected to cut the fiscal deficit from -3.0% in 2017 to -1.8% by fiscal year end and the current account deficit to -2.7% from -3.0%. If this can be achieved, the current stabilisation of the Rupiah should turn into a fullscale reversal and appreciation. Euphoria in the run-up to the election should also bring portfolio inflows. Jokowi looks as if he might be lucky and see oil prices remain low during the period of subsidy until H2 2019. This should also keep inflation under control and the twin deficits manageable. Sovereign debt held by foreigners has also reduced significantly, through a series of reforms by the BI and now stands at 37% (down from 70% in 2008). Reforms to the tax regime have further reduced corporate debt held in USD, although the SOE’s remain reasonably highly exposed.

By moving ahead of the Fed and providing continuous reforms, Bank Indonesia started to find favour with the currency markets and managed to stabilise the Rupiah and with it, portfolio flows.

The risk to this strategy is that the rise in rates is dampening demand for mortgages and the banks are starting to doubt the ability of the consumer to sustain the full round of rate rises in 2019, if BI continues to follow the Fed. At present, the economy remains supported by consumption, which is 50% of GDP and government infrastructure spending, which has been accelerated substantially since 2016. Many of these infrastructure projects are expected to complete in 2019, theoretically lowering the cost of logistics and lessening pressure on the fiscal deficit as they complete.

The relative buoyance of consumer confidence is sustaining imports at elevated levels, whilst exports have yet to really pick up properly. Higher mortgage rates may weigh on spending, but carefully targeted government spending and tax reliefs (eg for fishermen, teachers and agricultural workers) ahead of the upcoming 2019 elections should support confidence.

Exports to China and Japan both fell in October yoy (possibly due to the shift in Mid-autumn festival), but rose by over 10% to the US. As China and Japan together are more than double the trade with the US, the impact was the widest trade deficit in over three months, which prompted BI to raise rates unexpectedly. The larger deficit also prompted the Ministry of Finance to offer a new stimulus package aimed at mining, forestry, plantations and fisheries, which gives tax cuts to companies repatriating their earnings into the domestic banking system. Companies who do not keep their export earnings domestically will not receive the tax cut and may be banned from moving their goods overseas. Foreign ownership restrictions in many sensitive sectors will be removed in a substantial reduction of the “negative list” for investment.

The country is starting to emerge as a beneficiary of the diaspora in Chinese manufacturing, driven by multiple tailwinds: rising wages in China, the improved competitive position following the drop in the Rupiah and the CPPTPP and RCEP treaties were all preparing the ground for a rebound, but the Trump trade wars seem to be providing the final catalyst for companies looking to relocate.

At 17%, Indonesia’s household debt to GDP is not stretched and the lowest after India in the whole region. Corporate debt is 40.8% and government debt another 28%, making Indonesia one of the least indebted countries in the region. The impact should not be as bad as if this were full tightening, as the end of the cash-consuming projects should also coincide with improved efficiency after their completion. FX reserves have now stabilised and so the outlook for the Rupiah seems to have turned in Indonesia’s favour.

The picture painted by the economy remains mixed and still difficult for the stock market, but it does seem to have turned the corner now. Q1 2019 could be choppy, as China has clearly pulled forward orders in many sectors ahead of the imposition of US sanctions in January, which may produce a much weaker start to 2019 than markets have been expecting. However, BI’s structural reforms, improving FDI, an amelioration of the oil price and a stabilisation of the currency all bode well for Indonesia to sustain a modest recovery from here.

The economic backdrop has not been supportive for equities for most of this year, but does now seem to be improving.

Risk warnings
Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds. Our funds invest for the long-term and may not be appropriate for investors who plan to take money out within five years. Tax treatment depends on individual circumstances and may change in the future. The fund will be exposed to stock markets. Stock market prices can move irrationally and be affected unpredictably by diverse factors, including political and economic events. The fund will invest in shares in emerging markets which can be more volatile than more developed markets. Changes in exchange rates may affect the value of your investment. In certain market conditions some assets in the fund may be less liquid and therefore more difficult to sell at their true value or in a timely manner.

Regulatory Information
This material is for distribution to professional clients only and should not be distributed to or relied upon by any other persons. It’s provided for general information purposes only and is not personal advice to anyone to invest in any fund or product. The Key Investor Information Documents and the Prospectuses for all funds are available, in English, free of charge and can be obtained directly using the contact details in this document. They can also be downloaded from An investor must always read these before investing. Information taken from trade and other sources is believed to be reliable, although we don’t represent this as accurate or complete and it shouldn’t be relied upon as such. Calls may be recorded for training and monitoring purposes. Issued by Marlborough Fund Managers Ltd, authorised and regulated by the Financial Conduct Authority (reference number 141660). Registered office: Marlborough House, 59 Chorley New Road, Bolton, BL1 4QP. Registered in England No. 02061177.

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