Episode 46

Who’ll Be Your Plus-One? When China Becomes Your Investment Ex

By:

Senior Market Analyst at Interactive Brokers

As geopolitical tensions, and other challenging headwinds intensify, many in the market are shedding their exposure to China and looking more deeply at Asia’s diverse landscape. Matthew Appelstein, CEO of Americas and Head of International Distribution at Eastspring Investments, offers his insights into the region’s valuations, supply chain shifts, exports, and a host of other country-specific changes and opportunities for growth.  

Note: Any performance figures mentioned in this podcast are as of the date of recording (October 31, 2022). 

Summary – IBKR Podcasts Ep. 46

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Steven Levine

Hello, and welcome to IBKR Podcasts. I’m Steven Levine, senior market analyst at Interactive Brokers, and your host for today’s program. We’ll be speaking with Matthew Appelstein, CEO of Americas and Head of International Distribution, at Eastspring Investments. We’ll be talking about his insights into Asia’s markets, notably the recent volatility we’ve been seeing in China, and his view on investments in the region.

So, welcome Matthew! Thanks very much for taking the time to do this.

Matthew Appelstein

Thank you, Steven, for having me here today.

Steven Levine

Yeah, I’m excited. It’s really been a fascinating, fascinating journey looking at Asia these days. I mean, financial markets in Asia generally seem to be facing some really increasingly challenging headwinds. There’s been geopolitical concerns in China, more aggressive U.S. policy aimed at slowing advancements in Chinese technology – especially the semiconductor sector. This really appears to have just reverberated across not only manufacturing, but the entire ecosystem where these chips are required: electric vehicles, artificial intelligence – these are just a couple of examples. There’s also been some pretty significant currency challenges, given the tightening of monetary policy at major global central banks to combat inflation … this includes the Fed … strengthening of the U.S. dollar. So, there’s just a great deal going on in this region. And so, I thought we could start by asking you what your rationale is for building positions in Asia at this time? Why should investors consider this region, given what appears to be this long list of rising risks?

Matthew Appelstein

So, Steven, you’ve got a lot of interesting subjects you just mentioned. So, let’s start on at a macro level. Asia accounts for half of the world’s population, and by 2030, 53 percent of global Internet users are forecasted to reside in Asia. And in 2050, it’s going to have 50% of the world’s wealth – consumer spending and wealth will be in Asia. So, it’s a tremendous growth area. Where a lot of developed countries are dealing with slowing population growth, you’re seeing growth in Asia. So, the first thing to understand on a macro level is there’s a lot of interesting things happening in Asia.

So, it’s also really important to point out that people look at Asia – they say ‘Asia’ in a generic sense. You’ve really got to go behind that. So, there’s different types of economies in Asia. If we look at really the developed countries like Singapore, [South] Korea, and Japan to the middle-income countries like China and Malaysia, or really true emerging economies like India and Indonesia. So, Eastspring has people on the ground in there. We have locations in 11 different countries in Asia. So, we really have that understanding of ‘you can’t look at it generically’.

The other thing is, it’s going to be one of the fastest growing regions in the world. So, population growth supports GDP growth, and these two are really intertwined.

The other thing I’ll have to say is: The near-term challenges of what we’re seeing in a global slowdown and decelerating growth in the U.S., Europe, and China … it clearly is going to impact Asia, but there’s a lot of opportunities there. If we think about what’s going on, a lot of the emerging market countries’ balance sheets are in better shape. They’ve gone through this before. And we think they’re really prepared to take advantage of the turnaround when it comes. Right? Everything goes through cycles. So, let me kind of break that up into two pieces. It might be really helpful. Let’s talk about near-term from a near-term valuation perspective, and then longer-term, because there’s two things I’d say.

The first thing, and the most important thing … and if you remember anything I say today on the podcast … it would be valuations in Asia are some of the most attractive in the world today. So, after a decade of lagging the global peers both on an absolute and relative basis, we think this is an interesting entry point. So, we’re looking at price to books around 1.5 today. Those are well below historical averages. And if we’ve looked at this in the past, historically it’s delivered really strong returns after that. So, that’s the first thing.

The second thing is, if you look at growth and value, and you bifurcate the two, there’s a two standard deviation difference in the pricings of a growth stock and value stock today. So, tremendous dispersion in the marketplace. Again, we think that’s another opportunity in the short-term to take advantage of. And then if you think about what’s going on in the world – rising interest rates, COVID-delayed openings…. some of the rich balance sheets over there. We’re entering a decarbonization era. We’ve left the digitization era – all these tech companies really putting technology right in our fingertips. And what you’re seeing today is a lot of these tech companies have really reached a cap. Governments are concerned about the control that these companies have…. I’m not saying they’re not going to continue to grow ’cause they may well continue to grow, but we think the caps on growth are going to be different than before, and you’re starting to see that with Tencent and Alibaba falling into the value universe from really historically being very large growth stocks. So, what we’re going to see … this decarbonization is going to require the rebuilding of the manufacturing infrastructure, which tends to favor Asia, where a lot of the manufacturing is taking place. You’re going to see new factories created in new places, right? And we’re seeing people thinking about moving manufacturing closer to the home markets.

And then finally, I would tell you is, as a whole, the world is underexposed to Asia as an area of investment, so we see that as a tremendous opportunity. The percentage of ownership in some of the China markets is the lowest in almost anywhere in the world – U.S. ownership of those markets. So, tremendous opportunity for investments, which obviously will drive up the PE ratios there. So, in the short-term, that’s what I see is some short- term valuations, but again, going on the real critical component of valuations are some of the most attractive in the world today in Asia.

Steven Levine

I just I wonder about this though in terms of growth. There must be certain industries that these countries, say [South] Korea or Japan, or China rely on for their growth. I would think that, for example, a lot of these countries rely on, say, chips for manufacturing them or producing them for their growth … for their GDP, right? Much in the same way that the U.S. relies on consumerism for its growth. But the importing, say, of the raw materials to make these chips … the bans that U.S. has imposed on China…. Do you see this not as a short-term erosion that will have a ripple effect down the line for these countries?

Matthew Appelstein

Steven, it’s a really good point. So, I talked to you a little bit about the short-term, so let me pull back and talk about the long-term perspective. We believe in long-term investment horizons, right? We’re not an advocate of this short-term trading, but if you think of the longer-term, there’s three big things that are going on in Asia right now, which we think are substantial.

One is inter-regional trading. You’re seeing the emerging market countries trading with each other more. So, something’s made in China – they’re getting some goods from Vietnam, they’re getting some goods from Indonesia. A lot of the rubber [is] coming from Malaysia. So, that inter-regional trading is growing as a proportion. So, yes, exports matter, but that’s an important component.

The second thing is … we talked about it … is decarbonization. So, we need to reduce the carbon footprint. That’s going to occur a lot in Asia, right? So, that’s going to require capital, and so you’re going to see that.

The third thing is the digitization that we’ve talked about in the U.S., Asia is a little behind that. So, they still have the benefit of some of the digitization in their countries, and that’s going to be a helpful long term-trend as they move more into the digitization era. And those three things are really unusual that you have all of that going on at once. Because in the U.S., we’re not going to benefit as much from the digitization era, because we’ve gone through that. We’re at the cycle where that’s being tamped down. So, I think those long-term trends are really critical.

The other thing that’s going on right now, too, is … it’s called ‘China-Plus-One’. So, there seems to be some concerns throughout the world today on China; and, so, China-Plus-One means if I manufacture it in China, I need to have it somewhere else. So, today, there was a shortage in the United States of the imaging dye needed for MRIs, because the main plant where most of the dyes was coming from was in Shanghai, and it was in lockdown. So, that’s today’s situation. Tomorrow, what you’ll see is … China-Plus-One means I may have it in China, but maybe Indonesia or Vietnam is my backup. So, that ‘Plus-One’ is going to be big, and that wasn’t the case two years ago … five years ago. So, you’re going to see this kind of rooting effect, where the roots are going to spread out farther, and that’s where you’re going to see in Asia that you can bring that manufacturing expertise out of China into another country.

The second piece of this is … what’s going on in the countries of trade … is you’re still seeing trade going on with Europe and the U.S., and if China starts to become more inward-looking, the trade in the rest of Asia is going to be more outward-looking to the U.S. That’s going to have to be picked-up from somewhere. And I think on the chip side, I think it’s easy to misunderstand or misinterpret what’s going on with chips. I think the chip issue will be a critical factor in China, where some of our chips are not going to be able to make it there but [The Taiwan Semiconductor Manufacturing Company Limited] TSMC in Taiwan is going to be shipping the chips to the rest of Asia. So, you almost have to have a bifurcation of what are the two different markets there. So, I just wanted to kind of point out a couple of things that people kind of say there’s going to be a chip issue. I do think we may have two standards. China will have one, and the rest of the world will have one, like with Huawei but I think the chips in Asia, with Taiwan being so close, and TSMC is actually moving chip manufacturing into Asia and the U.S. So, you’ll see an additional supply. Obviously, there’s long lead times, but those are expected to open up next year … late next year. So, you’ll see an additional supply of chips in the U.S. and in other places in Asia.

Steven Levine

This is a rather political question, but would you suspect that the more, say for example, these bans from the U.S. on Chinese technology advancements take hold, or affect China in some ways, the more challenging it may be for Taiwan to keep its sovereignty?

Matthew Appelstein

It’s a really hard one to interpret, because we think of investments, and we think of investing in the long-term. China has 1.3 billion consumers. That’s a pretty large market to service. So, the China market – the number two market in the world behind the U.S. – it’s going to be a very robust market if it ultimately just services its own customers. I’m not saying that is where things are going to end up, but even if that were to be the case, there’s 1.3 billion consumers. It’s an aging economy …so, healthcare, healthcare technology … things like that can really be robust, and companies can do very well servicing those markets. And still, China will be able to trade with Russia and some other countries. So, I think we may be at a friction point right now, but I’m not sure it means we’re going to the direction of we’re going to purely cut off China or not. The political side is it’s still a robust market. It still has a consumer market three to four times the size of the U.S.  There’s going to be tremendous opportunity there for companies to grow and develop, and the stock prices to grow.

Steven Levine

I’d like to talk a little bit about emerging markets in general, because they’ve been a pretty mixed bag, haven’t they, for the past few years? How do you position in emerging markets when they all seem to be under pressure? I mean, the dollar itself is, I think, giving a lot of challenges or obstacles for emerging markets, given more expensive dollar-denominated commodities, et cetera, that they may need. But I’d love to hear your take on what’s happening with emerging markets and your thoughts there.

Matthew Appelstein

Steven, we’re hearing a couple things there, but first let me say if you just think about China, ’cause I think this is important to get on the record. China had a $2 trillion economy back in 2002. By 2022, it’s an $18 trillion economy. So, tremendous growth. So, this is what I mean about the size of the consumer market there. So, we believe China is here to stay and here to stay for the long-term, right? But when you think about emerging markets, China peaked at 40% of the Emerging Market Index. So, really what that does is it starts to crowd out other countries. Today, It’s down to 32%. So, what we’re hearing from our investors – what we’re hearing from the institutional marketplace – is people are looking at emerging markets differently. They’re saying, ‘Should I think about emerging markets in a homogeneous approach, or do I need to think about it differently?’ And what I mean by that is we’re seeing investors saying, ‘I want to break out my emerging markets into maybe GEM – Global Emerging Markets – ex-China, and maybe separate my Chinese investments out. So, today, many managers who have a GEM portfolio that’s not too concentrated … not 1,000 stocks … they may have two or three securities in Mexico, right? They may have one or two stocks in some of the Mideast countries. So, what you’re doing is … that crowding effect of having China, and the political risks, and the friction that’s going on in the world today … people are bifurcating and breaking out GEM ex-China, and that’s one of the things we’re seeing. But it’s too general to say ‘GEM’ is’ GEM’. It’s emerging markets. There’s so much diversity underneath there, but that’s the biggest trend that we’re seeing, Steven, and I think that’s something that you’re going to hear more and more about. That is just the beginning. The State of Wisconsin announced within the last six months that they’re breaking out their GEM mandates into GEM [and] GEM ex-China.

So, so you’re starting to see public funds look at that. We’ve had several U.S. consulting firms come to us – these are global firms say, ‘We really need a GEM ex-China portfolio because we have clients … maybe they’re in the Midwest … maybe they’ve had some bad dealings with China’. They want to separate and break out that allocation. So, that’s the other thing we’ve been seeing.

Steven Levine

That’s so interesting. It’s really interesting. I want to also pick up on your mentioning of decarbonization, ’cause you’ve mentioned that a couple of times, and I’m very curious about this. We’ve seen some effects in certain countries who have gone very quickly in a certain direction to remove, say, fossil fuels from their landscape, and there’s been some volatility in those countries where this has happened. How long do you think the trajectory of having a country, say the size of the landmass of China or India, would take to completely phase out all fossil fuels, and decarbonize, and build these factories as you’re saying? And commit to those goals or timelines that that they’ve given for the Paris Agreement to do? I mean, would they meet those goals? Is that something do you think it’s realistic? Or how do you see this unfolding exactly – the decarbonization?

Matthew Appelstein

What you’re going to see in Asia is, and today we’re seeing it … some of the premier firms in solar, wind … the manufacturing, and some of the development, is happening in Asia today. So, China has a bigger problem than we have. If you’ve ever been to Beijing on a normal day, they have a big problem.  They need to clean the air up. And, so, it’s a really big initiative of the Chinese government, and we have a lot of investments in China. We think that’s one of the areas where the world is really going to rely on China to still produce those type of goods for the rest of the world. It’s not easily replaced – that manufacturing expertise – because it’s pretty complicated …the solar panels, the turbines, the wind, and I think you’re going to go there. It’s a goal of China. Today, China sells more cars, produces more solar panels and turbines than any other country, so they’re really the leader in the renewables area. And as this China-Plus-One continues to expand; you’ll see that manufacturing moving to other countries. So, I think China is committed to doing that. How quickly that happens, it’s really a hard one to judge, but the valuations of investing [in] some of these have really come down with the rest of the world. We call it ‘throwing the baby out with the bathwater’, right? Everybody has been pushed down and that’s why the valuations are so attractive in Asia today.

So, this decarbonization is — the world still needs metals. We still need steel. We still need concrete, but the people that are going to be able to produce that with the least carbon footprint. And that’s going to be determined by the world’s investors, right? When we think about that, and that’s what’s going to happen. So, I think that’s the opportunity in Asia, where a lot of the world’s manufacturing is today, is who’s going to be able to do that – that decarbonization. And I can’t tell you how long it’s going to take, but I can tell you it’s going to create some attractive valuation opportunities.

Steven Levine

It sounds like there’s the enormous amount of growth potential. There’s an enormous amount of focus from countries … basically worldwide … that are seeking to decarbonize or lessen their carbon footprint. And if they’re going to invest in their own infrastructure’s energy … in solar or wind, it makes sense that those factories would need to be built somewhere, and I suppose, where those raw materials are to build them would be China and other countries within the Asian community. If I understand that right?

Matthew Appelstein

Yeah, so, if you just think Taiwan Semiconductor [TSMC] … so, they’re building a plant in the U.S. and Arizona; they’re building a plant in Japan. Both of those plants are each $12 billion plus investments. So, we’re talking just from the two plants, $25 billion in building plants outside of China for… And all these chips are needed for solar, for wind, for e-vehicles, right. So, the investments are going to be really large, and those, in our mind, create really interesting opportunities, because once you have a chip plant in the U.S., all of a sudden you have to create a whole feeder industry around that. The same thing in Japan.

Steven Levine

Yeah, it’s amazing – there’s such a huge transition that’s going on, and these outsized moves that these companies are making on the back of the potential growth, or, I mean, obviously, the advancements in technology in general are going to require these chips, like you say. And, so, the potential for growth is really just enormous.

Matthew Appelstein

There’s one other factor I should mention too, and I think that’s something that we’re … you know, we’re on the ground in Asia … it’s ‘Just-in-Time Manufacturing’, which everybody moved to is really the evolution of that will be: we’ll be moving away from Just-in-Time. Supply chain breakdowns that we’ve seen, which many people think is a big cause of inflation today, and shutdowns around the world, especially in China, are going to create more buffers in inventory. So, what we’re seeing is companies saying, ‘We need to build up inventory’. So, we think that’s another part of Asia having to retool, as we get back to some sense of normalcy … of not just to Just-in-Time Manufacturing, but building-in buffers of manufacturing. So, should there be a shutdown…  should something go on … we have extra inventory in place. So, we think that’s going to be a driver in consumer goods … inventories of raw materials. So, the supply chain disruptions are going to be interesting. So, let’s take Singapore. Singapore today has a plan to produce 30% of their food through vertical farming techniques, right — not a lot of land mass there — by 2030 because they’ve been historically overdependent on neighbors for food supply. From the food supply, countries are saying, ‘I need to bring more close to home’. We’re not just talking about manufacturing. So, these are these going to reverberate, these are going to be different changes … and then, auto manufacturers, electronic manufacturers, you can’t wait. If you have to stop production ’cause you can’t get a part, you’re going to start stockpiling more of it. And historically, up until COVID, the supply chain has been so efficient that we’ve been able to get by that. We think of the zero-COVID policy in China today – that really breaks that down, and nobody knows for sure when that changes.

Steven Levine

 I think you mentioned earlier about inter-regional trade as well, and so that sounds like a shift in supply chains as well – in terms of how goods are traded across borders these days.

Matthew Appelstein

One of the other things that I wanted to make sure people understand is today, the dollar is incredibly strong. When the dollar is as strong as it is today, buying and investing in Asia is … your dollar buys more. From a from a valuation opportunity, better to buy when the dollar is strong, because, ultimately, at some point, the dollar will move back to a more sense of normalcy. The yen/dollar exchange rate is at extremes right now. We know that in the U.S. dollar to the euro, to the pound. So, at times when the dollar is very powerful, buying and investing in overseas is cheaper. And then you get the benefit of the appreciating currencies in the future. And so, we see that as another unusual opportunity right now.

Steven Levine

But let’s say that the dollar keeps rising. At what point does it become untenable for certain of these Asian countries – in terms of the creditworthiness of these countries, of the growth of these countries, to contend with a strengthening U.S. dollar?

Matthew Appelstein

So, there’s two parts to this – the strengthening U.S. dollar. You’re focusing on one part of the equation, but there’s a symbiotic relationship. As the dollar strengthens, the goods that are manufactured in Asia become more attractive to you to buy in the U.S., which actually helps with our inflation issue. So, the countries in Asia are going to benefit by the strong dollar by having cheaper-priced goods to ship to the U.S. It makes their goods more attractive from a trading perspective. So, yes, there is the currency … there’s the FX headwind, but there is the benefit of having cheaper currencies, and therefore being able to bring goods to the U.S. at a cheaper price and help the flow of trade. So, these countries do have that outlet to offset what’s going on the currency side, okay.

As I said before, remember Eastspring … we look at ourselves as Asian experts. We live in Asia. We reside in Asia. The balance sheets of many countries in Asia are much stronger than they have been in the past. Japan – the cash on the balance sheet in the Japanese market is very strong. So, you’re seeing a lot of companies in Asia well-positioned financially to withstand some of what’s going on. And if you throw in increasing exports, with this strengthening of the dollar, it’s a two-edged sword for the U.S., so it allows us to bring in cheaper goods. And it allows us as investors to buy things cheaper to invest in the companies there. So, there’s two sides of that. So, yes, there will be some financial pain for these companies, but there is a plus side to that. If we look at Japan – for many years, people worried about Japan and stagflation. And Japan, at one point, used to apologize to their customers for raising prices. Well, today inflation actually in Japan is not such a bad thing, because it allows the Japanese manufacturers and companies to raise prices, something that hasn’t occurred in Japan in a long time.

So, each country … I started out early to say we can’t look at Asia as a mass. We have to understand what’s happening in Indonesia. Several countries in Asia have strengthened raw materials, and the price of raw material strengthening has helped those countries. It’s a much more detailed understanding. You can’t say ‘emerging markets is in trouble,’ because each of the countries can benefit in different ways.

Steven Levine

Yeah, I completely get it. You’ve got these idiosyncratic benefits that you would get from specific countries within the region, and that makes a lot of sense to me. This has really been great. Are there other any other points within specific countries, or specific markets, that you think might have growth potential outside of those that we’ve talked about?

Matthew Appelstein

What we’re seeing is every country has unique opportunities  whether it’s Indonesia, Malaysia, Singapore. We’re seeing Singapore take the lead in clean energy. So, we’re seeing a lot of really interesting investment opportunities in Asia … sustainable type bonds coming out of Singapore. So, each country brings different opportunities to it and, if we go back to that premise of these really attractive valuations in Asia today … the world is underweight investing in Asia, as a whole that we see that as attractive. If you look at price to book at 1.5, that’s historically a very low number. We just see attractive opportunities, and to us, that’s the opportunity to spend some time, and understand, and think about that as a really interesting place to invest today.

Steven Levine

You sort of get it while it’s hot, I suppose – the operative words there. I wanted to ask why you think people are underweight Asia?

Matthew Appelstein

Everybody looks at Asia as China, and that’s probably one of the biggest obstacles you face right now Is China. People look at China and Japan, and then they’re just not sure –what does Indonesia do? What does Vietnam do? And Vietnam is really going to be one of these up and coming…. It has one of the youngest populations in the world, a really large population of employees to work in the factories, and it’s one of the first choices people look at to move out of China is to move into Vietnam.

If you look at Pottery Barn –a lot of Pottery Barn furniture is now coming from Asia. It used to come from North Carolina, South Carolina in the U.S. Now, it’s coming from China and Asia and as people have an aversion to China, you’re seeing much more come from Vietnam and Thailand and Indonesia. So, it’s fascinating. And so, as you see, people go up the value chain. [South] Korea is where the TV’s come from today, right? I mean, if you want a high-end TV, it comes from it comes from [South] Korea. It doesn’t come from the United States … doesn’t come from China. So, they’re really building a space higher up in the value chain in Asia. They started out as everybody had their clothes there, right? You pay someone nothing an hour, [but] you have to pay someone more if they’re going to build a TV in a clean factory.

Steven Levine

Wow, this is great, Matthew! Thank you so much! Thanks so much for taking the time to do this! I wanted to let our listeners know that they can read more market commentary, and analysis, and insights from Eastspring Investments at IBKR Traders’ Insight at tradersinsight.news. They’ve got a lot of fascinating articles there – some recent topics delve into value investing in Asia, and also Vietnam’s digital boom, and deriving value from Japan’s ESG potential. They’ve got a lot of a lot of great work there.

Matthew, thank you.

Matthew Appelstein

Steven, thank you very much for your time today. I look forward to it. And we’re here – Eastspring Investments – headquartered in Singapore. We look at ourselves as the Asian experts. We’d be more than happy to help your listeners out, should they have further questions.

Steven Levine

That’s really terrific. Thank you so, so much. That’s really great. So, until next time, I’m Steven Levine with Interactive Brokers.

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