Asia Pacific is well-placed to ride out the storm
The world economy is at a challenging juncture today. Consumer price inflation remains elevated, driving many central banks to push interest rates up aggressively. In turn, tightening financial conditions, on top of ongoing geopolitical concerns – such as the Ukraine invasion and mounting U.S.-China tensions – is also starting to dent business and consumer confidence.
While supply chain concerns have abated somewhat, falling but still high energy prices continue to pose downside risks to the near-term global growth outlook. It also remains to be seen how much further central banks will go in order to rein in still strong inflationary expectations, especially as sturdy consumer spending – backed by relatively robust labour markets – has so far helped to mitigate a more severe slowdown in real demand.
With recessionary risks rising in parts of the world, Asia Pacific will not be immune to the headwinds trailing the global economy. While growth prospects are decidedly less positive in the near-term, Asia Pacific is well-placed to ride out the storm. Over the long-term, there are also strong structural and fundamental reasons supporting the case for investing into regional property markets.
We believe that investors should continue to invest across cycles, especially in Asia Pacific as the fundamental dynamic continues to reflect the highly attractive structural trends underpinning long-term occupier demand.
Take heed: Caution is still in the air…
Regional growth prospects remain bleak heading into the second half of the year. Stock markets are languishing, suppressed by the weakening outlook for corporate profits. Clarity over the credit environment in China is still clouded by Chinese developers’ default on offshore loans, although investors are hopeful that policy easing on residential purchase restrictions can help contain a broader systemic risk to the economy.
Global supply chain disruptions may have eased somewhat, but regional manufacturers continue to face shortages in some raw and intermediate goods, dampening the outlook for production and exports. The less-than-sanguine business outlook is likely to overshadow labour market conditions ahead (particularly wage growth), which alongside elevated inflation, may drag down consumer disposable income, sentiment and spending, thereby posing further downside risks to growth prospects.
Things will worsen before they get better
Consumer prices are hovering near-decades high levels across many Asia Pacific economies, and regional central banks are still playing catch up to strong inflationary expectations. Consensus continues to expect an upward march in policy rates, underscored by recent 10-year bond yield readings surpassing pre-Covid levels. Even as the market expects price pressures to ease somewhat next year, it is likely inflation will stay more persistent than initially expected.
Monetary conditions too are likely to continue tightening into 2023 before easing off but even so, highly unlikely to return to the low-for-longer policy landscape the market is accustomed to since 2008. A higher rate environment is likely to suppress on economic activities, not least of all business capex as well as consumer spending in highly leveraged household economies. Japan and China are exceptions. But in the case of the Bank of Japan sticking to yield curve control, a widening interest rate differential and a subdued economic outlook has led to a sharp depreciation in the yen and sharply higher imported inflation.
A policy shift is unlikely during the remainder of Governor Kuroda’s remaining term, raising the risk of further yen weakening and intervention by the Bank of Japan. This is the same in China, where policy loosening and the weakening RMB reflects unease over the worsening economic outlook and deeper rooted concerns over structural weaknesses.
Despite this, regional growth has been sequentially downgraded since the start of the year. Both Japanese and Hong Kong economies managed to avert a technical recession in Q2 but the weak rebound calls into question the strength of the recovery heading into 2023. The lockdowns across multiple Chinese cities, including the commercial hub of Shanghai, led to a sharp -8.7% contraction in Q2 growth, reversing the 7.4% expansion in the first quarter. Consequently, China is now expected to grow at only 3%, substantially below trend growth and the 5.5% official projection this year.
A slowing China, the biggest trading partner to many regional countries, does not bode well for near-term regional growth prospects. Meanwhile, ongoing U.S.-China trade and geopolitical tensions, a still uncertain outlook for inflation and tightening financial conditions implies the near-term outlook for Asia Pacific looks uneven at best.
A long-term resilient story
There are many valid and compelling reasons why Asia Pacific can emerge from the current downturn relatively well-positioned. Foremost, the region is anchored by sound fundamentals:
- Headline consumer prices may have escalated to multi-year highs, but core, sticky inflation (excluding food and energy) is still quite well-contained, potentially allowing more flexible central bank monetary policy maneuvering to manage future growth.
- Foreign currency reserves and current account balances across many regional economies are healthy, providing strong external defenses to volatile capital flows (figure 1).
- While the pullback in government support programs initiated during the height of the pandemic and rising inflation has led to a decline in personal savings rate so far this year, healthy personal and household balance sheets still stand in good stead to mitigate against any unexpected prolonged downturn (figure 2).
- The build-up in fiscal reserves since the global financial crisis can allow regional economies to smooth out economic cycle volatility. Structurally, Asia Pacific is the hotbed of megatrends: By 2030, Asia Pacific, led by China, will account for nearly half of the world’s output, with more than 50% of the world’s urban population and almost all of the top 50 global cities with the largest forecasted change in wealthy households. Asia Pacific’s growth will continue to outpace the global average in the coming years, even with a managed slowdown in China. Over the same period too, the region’s share of global consumption will rise to around 35%, as middle classes continue to emerge. Asia Pacific is now the wealthiest regional economic bloc in the world, with net household wealth more than doubling and Chinese consumers being the biggest buyers of luxury products. By any account, the region is the epicentre shaping tomorrow’s world, with strong and resilient growth, untapped demographics and technological adaptability.
Capital will continue flowing into alternative real estate given the unique mix of positive demographics and limited investability underlining immense growth opportunities.
Near-term delicacy is needed
There remains a lot of equity –more than $50 billion by some estimates – still waiting to be deployed into the regional real estate market. But in a low cap rate, projected weaker occupier and rising interest rate environment, projected returns are likely to be lower than the already tight levels expected today, with the balance of risks to the downside.
The risk premium may be even higher in sectors heavily sought after by investors over the past two years of the pandemic. With cap rates approaching that of prime offices, the logistics sector is at the mercy of oversupply and weaker demand in some markets as consumers transition out of an over-reliance on online shopping. Accordingly, as third-party logistics (3PL) operators re-adjust space requirements, market rents are likely to trail lower, narrowing the gap with in-place rents and limiting rental growth prospects. The ball may be in the tenant’s court for the foreseeable future. Even in fundamentally robust markets such as Seoul where competition has driven office cap rates down to cyclical lows, income is now decretive as yield spreads turn negative on rising borrowing costs.
Long-term benefits persist
At this moment, investors should play the long game. The bid-ask spreads in some markets remain tight but are likely to widen as caution seeps back into the market. As a result, investment volumes across the region this year are likely to be lower after reaching record highs in 2021.
There remains pockets of interesting opportunities but price expectation will need to be recalibrated in light of rising borrowing costs and growth risks. Over the near-term, investors should focus on the fundamental dynamics of sub-locations in structurally robust cities and into relatively nascent sectors with untapped growth opportunities. Counter-intuitively, some markets may also benefit from rising construction and labour costs, as development delays forestalls new supply pressure.
In land scarce Singapore, increasing focus on ESG activities will likely boost long-term occupier demand for prime offices. Japan senior living still provides a unique window of opportunity to tap into a slowly maturing sector with long-term tenant demand. In Australia, build-to-rent and student accommodation remains well-underpinned by supportive demographics.
The secular growth in consumer spending also bodes well for Chinese discounted luxury outlets. Over the longer-term, Asia Pacific is well-placed to ride out the storm, and for global investors looking to diversify into the region, the more resilient near-term fundamentals and robust long-term structural trends should help position investors well for the future.
An allocation into Asia Pacific is about diversification into the region’s structural and cyclical resilience to enhance overall portfolio returns.