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KKR White Paper – Asia Macro Trends: Global Growth Engine, Key Themes, Concerns

Global Macro Trends – Asia: Leaning In, October 2017

“We believe that Asia ex-Japan is now finally poised to outperform. As a result, we have boosted our exposure to this region of the Global Capital Markets”

Primary Conclusions:

  1. Asia’s surging middle class, coupled with strong productivity trends, signal robust structural growth for the foreseeable future
  2. From a cyclical growth perspective, we think that China’s nominal GDP growth has already crashed, which has important and positive implications for the way we view the Asian emerging markets story during the next 3 – 7 years
  3. We see Asia as a direct and compelling play on three of our global macro themes: de-conglomerization, experiences over things, and the illiquidity premium within performing private credit
  4. The biggest changes in Asia we see are not only the continued migration up the value-added ‘food chain’ across a variety of domestic industries but also the impact that technology is having on delivery of these higher value-added good and services
  5. Beyond strong growth in domestic demand stories, we also see more opportunities for allocators of capital to help Asian companies – both in developed and developing markets – expand abroad

Asian Growth: The World’s Global Growth Engine

“In a world largely starved for structural growth, both cyclical and secular forces are now working in concert to create a favorable environment for capital deployment across many parts of Asia”

  1. 60% of total global growth will likely come from China and Emerging Asia in 2017
  2. Asia has replaced the US as the driver of global GDP
  3. Middle class population in Asia will grow 153% from nearly 1.4 billion in 2015 to 3.5 billion in 2030
  4. Across much of the developed markets, labor productivity growth is not what it used to be, but that is not the story in Emerging Asia, as productivity growth remains robust (China, India, Vietnam, Indonesia)
  5. By 2030, 4 of the top 10 economies could be in Asia (China, India, Japan, and Indonesia)
  6. Also believe GDP-per-capita will improve meaningfully

Key Themes / Insights on Why We Now Hold a More Positive View on Asia as an Investment Destination

“Our EM model, which began to inflect upward in early 2016, is now actually pointing towards the beginning of the ‘mid-cycle’ phase of a long-tailed recovery”

“Beyond compelling macroeconomic conditions that we now see, Asia has now also emerged as an elegant play on some of our highest conviction investment themes, including corporate carve-outs, experiences over things, and the illiquidity premium”

  1. Nominal GDP growth in China fell 68% from 2011 to 2015 but nominal GDP has again reaccelerated in China
  2. With supply being rationalized, Chinese industrial profits appear to have bottomed
  3. It has been a long, hard road in EM but we now believe a structural turn is occurring
  4. EM is now entering the ‘mid-cycle’ phase of its recovery; wherein relative valuation is no longer compellingly cheap, momentum has turned and fundamentals are improving
  5. Think margins have bottomed and free cash flow is up across EM
  6. The USD is now closer to a peak than a trough in our view
  7. The low US unemployment rate suggests current account dynamics could soon move against the USD, benefitting local players in Asia that export abroad
  8. Real yields in Emerging Asia are now higher than in many developed markets
  9. EM current account deficits have improved in many instances
  10. Cumulatively, the currency impact on MSCI EM returns has negated most of the gains since 2009. We think this headwind is about to become a tailwind
  11. We have materially shifted our sovereign debt holdings in our target asset allocation from developed market local debt towards local EM debt securities
  12. Tech has surpassed Financials as the largest sector in EM, taking share from Energy and Materials. Tech sector is driving 2017 earnings growth expectations
  13. Rate of returns for Foreign Direct Investment declining in many areas of the global economy
  14. Local and regional competitors are increasingly challenging the returns of the multinational firms
  15. Investors can now look to more mature economies as funding sources, particularly in a slow growth world
  16. China’s economy is just $11.2 trillion vs. $18.6 trillion for the US, yet it has 1.6x more savings
  17. Unlike many other markets, Japan’s valuation still appears reasonable (9.4x EV/EBITDA as of September 2017)
  18. We believe there is great potential for operational improvement in Japan, including better margins, faster asset turns, and more efficient leverage
  19. Korean Chaebols’ recent non-core divestiture activity has been significant
  20. Chinese millennials not only save less but also allocate more of their income to leisure
  21. Given the bifurcated demographics in Asia, the potential remains quite significant in both developed and developing markets
  22. Japan: shift towards services as the population ages
  23. APAC tourists accounted for more than 25% of global international arrivals in 2016
  24. There is a need for the private sector to supplement existing healthcare infrastructure and to provide more and better access to healthcare professionals
  25. Rise in Services is playing out globally with Asia helping to lead the charge
  26. Emerging market private credit is increasingly another interesting play on our illiquidity premium thesis
  27. India has a relatively high cost of equity and as such, in a higher growth economy with strong nominal growth, local debt is often a more palatable capital markets solution for entrepreneurs
  28. With GDP-per-capita growing so strongly, total EM consumption is now growing 3x as fast as total DM consumption
  29. EM share of global consumption has exploded in recent years, despite a more sluggish growth environment
  30. $32 billion worth of mobile payments will be made in 2021 – 10x that of 2013. When it comes to mobile payments, China’s activity dwarfs that of the US
  31. Smartphone ownership rates in emerging and developing nations are rising at an extraordinary rate, having already climbed from a median of 21% in 2013 to 37% in 2015
  32. More than 80% of India’s internet usage occurs on mobile phones, with Indonesia not far behind
  33. Number of Amazon India fulfillment centers has increased 30% y-o-y since 2012 while the number of inventory SKUs and sellers has increased 2-3x y-o-y
  34. Regional trade over global trade: Trans-Pacific Partnerships’ demise may be Regional Comprehensive Economic Partnership’s windfall
  35. Asia trade connectivity will likely be more important on a go-forward basis
  36. EM is increasing its share of global M&A; within Asia, outbound M&A is much more than just a China story (Japan, Singapore, Hong Kong, South Korea, India)
  37. China is rebalancing towards high value-added exports and is gaining significant market share across more higher value-added sectors

Concerns

  1. China’s banks are levering up, similar to US banks before the GFC
  2. China is using recent spikes in its repo rate to rein in lenders that are borrowing short and buying long duration assets
  3. If credit growth slows to 12.5% and GDP grows at 9%, China debt-to-GDP could hit 300% in 2021
  4. Authorities are using the current GDP strength to tackle deleveraging in the financial sector
  5. Economic sanctions have proved ineffective in dampening North Korean real GDP growth and the number of North Korean provocations has increased dramatically since 2011
  6. Despite rising geopolitical tensions, risk premiums have actually fallen in many parts of Asia
  7. CDS spreads too have tightened; we believe that the opportunity for them to widen at some point remains quite high
  8. While China’s exports remain strong, its imports are declining – this is occurring at a time when global trade is in decline

Image Source: Knight Frank Research The Wealth Report 2012, Citi Investment research and analysis Global Growth Generators, KKR White Paper

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