Investors should pay more attention to stock picking and underlying fundamentals when investing in Asian equities as valuation gaps have tightened in the wake of general market optimism based on improving economic conditions despite the continuing challenges of Covid-19.

“Average price to fair value estimates for our Asian coverage narrowed further to 1.0x on optimism over vaccine availability and take-up rates, improving economic conditions, and further stimulus continued being priced in. With valuation gaps having tightened over the last quarter, stock picking is becoming more important and investors should pay closer attention to the underlying fundamentals. Selective opportunities remain across the consumer cyclical and technology sectors, while drug manufacturers and biotechs within healthcare are attractively valued,” says Lorraine Tan, Morningstar’s director of equity research in Asia.

However, the tug of war between growth expectations and inflation fears continues amid strengthening growth expectations in the United States and other developed-market economies.

“The positive expectations, driven by widespread Covid vaccine distribution, has resulted in an 80bp spike in the US 10-year yield since early January 21, and it seems to have stabilized in the 1.6-1.75% range over the past month.  The consequent contraction of US-emerging market (EM) yield spreads has led to an outflow of funds from EM bond markets and a moderation of EM currencies,” says Manishi Raychaudhuri, managing director and head of equity research, Asia-Pacific, at BNP Paribas Asset Management.

The underperformance of Asian equities appears to underscore this currency concern. Since February 21, the S&P500 has sharply outperformed the MSCI Asia ex-Japan Index (MXASJ) led by stronger growth expectations and improving employment generation.

Weaker currencies

The MXASJ was depressed by concerns about Asian currency moderation leading to outflows and renewed waves of Covid-19 infections forcing reinstatement of lockdowns and in turn upending the nascent economic recovery.

“Clearly, the market appears to believe the ‘improving growth’ narrative when it comes to developed markets and the ‘higher cost of capital and weaker currency’ narrative when it comes to EM,’ Raychaudhuri says.

In Asian equities, valuation in the financials and real estate sectors, in particular, narrowed in the first quarter of 2021 and only selective opportunities remain. Nevertheless, these two sectors outperformed the index on a relative basis during the second quarter, although they were laggards in Q1, according to Morningstar’s Asia Equity Market Outlook Q2 2021.

The Morningstar Asia Markets Index saw more moderate gains of 5% in first quarter. With the exception of healthcare and consumer cyclicals and defensive stocks, all other sectors posted positive returns during the quarter.

“We see the largest gap to fair value in healthcare names after a recent pullback in share prices on competition concerns and pricing pressure. We believe stock picking is key to finding value among the technology and consumer cyclicals,” Tan says.

Despite the tightening valuations, equities remain the preferred asset class over fixed income for asset managers as fears of a sudden spike in inflation in the coming months continue to dog bonds.

Equities preferred

“Our core view on asset allocation remains – equities are preferred over fixed income and corporate credit, especially high-yield corporate credit in the US as well as emerging market fixed income is preferred over government bonds,” says Tai Hui, chief strategist for J.P. Morgan Asset Management.

H-shares of Chinese banks have rallied 14% since the start of 2021, driven by improving macroeconomic conditions and an expected recovery in net interest margin (NIM). Valuation remains attractive at the historical trough on fiscal 2021 price/book value of around 0.4 to 0.5 times for the Big Four banks and 0.3 to 0.4 times for joint-stock banks except for China Merchants Bank.

“We expect positive rerating for large banks on further improvement in credit quality and fee income growth. With easing competition from fintechs and smaller banks, NIM increase from tighter monetary policy and higher fee income should lead to about 6% net profit growth in 2021. This compares with a 5% decline in net profit in 2020. Slower increase in credit cost is also supportive of net profit growth,” Tan says.

Chinese drug maker stocks have pulled back from the highs of 2020 as lower reimbursement pricing and more competition among PD-1 inhibitors have fuelled concerns about earnings this year as well as the long-term peak revenue of new drugs.