Can Asia withstand a US recession?

Australian Financial Review, January 2008

If you’re thinking of investing in Asia, there’s one question you need to think about before you make your decision, because it could make a big difference to how your investment works out. Does Asia still need a booming America in order to grow? Or is Asia strong enough now to keep growing even if the US goes into recession?

The problem is, this question divides professional opinion right down the middle. You may hear it referred to as the decoupling debate. On one side is this theory: Asia, once so reliant on trade with the west and the US in particular, has grown up. Its economies and banking systems are much stronger than they used to be, its companies are better run and far less laden with debt – and in particular, intra-Asian trade (Asian countries trading with other countries) has become so strong that the region can withstand a recession in the States.

On the other side: the argument that Asia needs vibrant exports to grow, and that with America in recession, that wouldn’t happen. Intra-Asian trade, in this argument, is mainly just Asian countries sending components to other Asian countries which are then assembled and re-exported to the west – meaning that the end demand really remains in the US, and so would be scuppered by recession.

Nobody doubts that America is slowing down; the question is how much, and what the knock-on effects will be. “The depth and length of the US slowdown is a subject of much debate,” says Michael Blythe, chief economist at the Commonwealth Bank of Australia. “Views are increasingly swinging in favour of recession as the most likely outcome.” For his part, Blythe reckons “a US recession is not yet a certainty,” but will eventually come down to “the consumer’s need, willingness and ability to spend.” In the States itself, views tend to be more miserable, such as this one from David Rosenberg, the North American Economist at Merrill Lynch in New York: “Recession is no longer a forecast but a present day reality.”

And Asia? Considered in isolation, it looks very healthy. According to Barclays Capital, nominal GDP in US dollar terms was up 19.2 per cent in emerging Asia in 2007, to US$7.52 trillion (although that astonishing figure gets a big boost from the falling value of the US dollar). Barclays expects it to climb another 17.9% in 2008. In 2007, again in dollar terms, emerging Asia was a more powerful engine of global growth than the USA, contributing $1.2 trillion of nominal GDP growth, twice that of the US. In 2000, emerging Asian economies were worth less than a third of the USA; today they’re equivalent to 54% of it, and should pass two thirds in the next few years, according to Peter Redward, director and head of rates research for emerging Asia at Barclays Capital in Singapore. “Emerging Asia is moving from being vulnerable to global cycles to a driver of them,” he says.

Redward is in the optimistic camp. He believes emerging Asian GDP growth is going to slow in 2008 and 2009 – but slow to 8.7% and 8.2% respectively (from 9.4% in 2007), which is hardly a slump. Yes, net exports will probably take a hit, bit domestic demand is well supported by both consumption and investment, he says. He argues that, apart from a period between 1998 and 2003, Asian and US GDP growth has scarcely been correlated at all, even though Asian exports have always been very closely linked to US industrial activity, which appears to suggest that exports aren’t as vital to Asia as is commonly assumed. Asian companies are healthy, with strong balance sheets and good earnings projections. “Our view remains that Asia is in pretty good shape,” he says.

He’s not alone. “The argument for emerging market equities is not that they are going to ride through a US slowdown unscathed,” says Richard Urwin, London-based head of asset allocation at Blackrock, one of the largest fund managers in the world. “It’s that they don’t follow the US to the destination the US is at now. If we’re right in thinking we will get slower growth in emerging markets but not a very dramatic slowdown, then this will still be a region that delivers significantly positive earnings growth.”

However, a very different view emerges from Ifzal Ali, economist at the Asian Development Bank. He has looked closely at the question of whether Asia is decoupling from the rest of the world. “The answer,” he says, “is a resounding no.”

“Pre-crisis, there were signs that Asia was decoupling,” he says. “But if you look at post-crisis Asia, the correlations have become much, much stronger. Anything that happens in the G3, within a one to three year lag, there is an effect in Asia, and the effect is much more pronounced than it was.”

At the heart of this difference of opinion is the question of regional trade.  “It has been very fashionable to talk about this,” says Ali. “But what is happening is that the explosive growth in intra-regional trade is all in one category: components and parts.” Ali’s argument is that most of these are then exported to China, where they are assembled into something else, before being exported again – to the west. He says that when this is considered, 79 per cent of exports from Asia end up in G3 countries. In those circumstances, “there is going to be a ripple effect on Asia. It’s just that, given the growth dynamics we have in Asia today, the effects are not going to be as catastrophic as they would have been 10 years ago.”

Redward responds that the composition of regional trade is changing, and that more and more of it goes to end users rather than for assembly into something else.

In any event, another important question is not just what the outlook is for Asia itself, but Asian stocks. We have often seen that economic performance does not translate into market performance, and valuation is an issue in some markets. Asia broadly is trading on a price earnings multiple of 15 times (based on the DJ Asia Pacific index), which is higher than Europe (10 to 13 times depending on which index you use) but lower than the USA’s S&P 500 at 18 times. So it looks fair value, although it is quite unusual in recent times to find Asia trading at a premium to the rest of the world, as it is today. But remember that different markets have different valuations: while Thailand’s SET index trades at only 10 times earnings, India’s Sensex index is trading at 26 times, and the Chinese A-share market a whopping 51 times, based on MSCI numbers.

Redward says he is “still modestly positive on Asian equity markets from a fundamental perspective, but in the short term they are likely to trade sideways.”And this is an important point: it’s one thing to look at fundamentals, but one also has to consider sentiment, and it remains the case that drops in US stock markets still tend to be reflected elsewhere in the world, Asia included.

 Generally, analysts favour particular pockets. Merrill Lynch is currently suggesting an overweight position in Hong Kong rather than China stocks, based on liquidity inflows, asset reflation, strong economic growth and convergence with the nearby Pearl River Delta area, solid corporate balance sheets, and upward earnings revisions. Citigroup’s Asian equity strategists reckon Taiwan is the most attractively valued market in the region, followed by Thailand and Korea (with India the most expensive).  And Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, has a different view again, arguing that despite the high multiples, “India offers investors opportunities in shares, property and infrastructure that should not be ignored.”

Urwin at Blackrock still likes the more expensive markets: India, China, and (despite losing 10 per cent in the first two weeks of the year) Hong Kong. “I would much rather they were trading on P/Es of five,” he says. “But are they on ludicrous valuations? They’re not. I think we’ll see people pay up for where the earnings are. Just going for the cheaper markets this year because they’re cheap may not be the right thing to do. Where the earnings are, the returns will be.”

BOX

Those who do want to invest in Asia, or emerging markets generally, have more opportunities than ever before to do so. There are numerous mutual funds available now that focus just on emerging markets, just on Asia or even just on China or India; in addition, it is easy for investors to follow indices at a regional and country level through the new iShares range of exchange-traded funds.