Smart Investor: Earning It, May 2012
1 May, 2012Smart Investor: Earning It, June 2012
1 June, 2012Emerging Markets, May 2012
For investors, Asian equities provide an unhappy conundrum. Asia is where the economic growth is, the best demographics, the emerging champions and the rising middle classes. Yet last year stock market performance in the region was the worst of any major market worldwide – including Europe, the source of global malaise.
Why? And when will Asia’s role as the engine of the world economy be reflected in share price performance?
At the heart of this contradiction is the nature of international capital’s behaviour towards risk. When the global economy, or a major western component of it, perceives risk – through problems in the banking sector, or sovereign debt – then money adopts a risk-off approach and flees emerging markets to go to defensive assets, usually in dollars. When the same pattern reverses, and risk-on positions are in favour, markets look very different, as we have seen in the first quarter of this year: according to HSBC, Asian equities suffered outflows of US$13.4 billion in 2011, but inflows of US$27 billion in the first three months of 2012. Consequently Asia ex-Japan saw 25% declines in stock market values between April and October last year, yet the MSCI Asia index was up 14.6% in the first three months of this year.
The volatility isn’t helpful, and the flight of capital during western troubles is illogical. Emerging markets are not, by any stretch, the world’s riskiest markets these days, particularly if one is looking at debt positions. But it never seems to change.
Nor does anyone expect it to in the near future. “If you look back there is a very consistent history of the key driver of equity performance in the region being economic growth – and that is highly correlated to global growth,” says Andrew Swan, head of equities for Asia at Blackrock. “Anything that has the potential to impact global growth affects equities here. That’s why you see sell-offs when political issues arise in Holland or Spain which on the surface may seem totally irrelevant.”
Others agree. “Asian stocks, as always, remain vulnerable to shocks and market swings coming out of the US and Europe because of the impact on fund flows into the region and the vulnerability of Asian exports,” says Shane Oliver, chief investment officer at AMP Capital Investors. “If US and European shares experience another setback of the European crisis or global double dip worries, then Asian shares will fall as well.”
This irksome trend notwithstanding, Asian equities do look good when viewed from fundamentals. Forward price earnings ratios on Asian stocks are, on average, around 10 times, Oliver says, compared to 11 a year ago, suggesting good value. Korean shares, in particular, are cheap. Even in domestic China, often considered the flag-bearer of crazy valuations, today’s (historic) PE of 12.7 times is dramatically below the long term average of 32 times earnings. Additionally, the mindset of Asian central banks has changed: a year ago they were tightening monetary policy because of widespread concerns about inflation, particularly in India, Indonesia and China (where inflation eventually hit 6.5% mid-year). “Now, inflation around the region has faded as a major concern and central banks have eased up on the policy break,” says Oliver. And on top of that, the unarguable long-term fundamentals for the region – low debt, rising middle class, growing consumerism – are still there.
“Taken together, this all suggests gains in Asian shares over the year ahead even though we may go through a further short term rough patch or correction driven by concerns about Europe and the US.”
The hard part is interpreting whether those low valuations are justified or represent good value. Swan is, broadly, positive. “Our central view is that the LTRO in Europe has given central bankers time to come up with solutions: a muddle through scenario. Under that scenario, and without contagion, Asian equities do look good,” he says. “Asian equities are trading at a PE around the trough level, and at 1.7 times price to book. They’re already discounting a lot of bad news there.”
But Oliver’s and Swan’s views – which are the norm in Asia Pacific – are not universally shared.
“We believe the potential underperformance of Asian equity markets versus developed markets could last for years,” says Ajay Kapur, strategist at Deutsche Bank. This isn’t to say that these markets will do badly – the Deutsche house view is “moderately positive” – but that it would be wrong to expect greater performance here than in the developed world. As he puts it: “The risk-love advantage that Asian equities enjoyed is gone.”
Kapur’s view is that, even if valuations are historically low in Asia as Oliver contends, they’re lower elsewhere. “EPS expectations for the US and Europe have now dropped to exceptionally low levels, while in Asia, these estimates are no longer low but quite punchy,” he says. Other reasons include excess capex eroding EBIT margins in Asia and “only nascent brand power.”
Naturally, it’s important to distinguish between the many different markets in Asia and their outlooks. In India, for example, the economy is now threatened by a strong chance of a downgrade to junk bond status (from Standard & Poor’s if not the others) while it wrestles with its fiscal deficit, debt burden, political gridlock and a growing vulnerability to external portfolio equity flows (and therefore external shocks). Yet in Indonesia, the country has been galvanised by an upgrade to investment grade status and remains insulated by the strength of its domestic economy. In the Philippines, too, the discussion is of upgrade potential, while in Taiwan it’s largely about realising the potential of cross-straits relations and working out how a gradual US recovery will affect the electronics sector.
But no discussion gets far without focusing on China. “In Asia, the critical question is China,” says Steen Jakobsen, chief economist for SaxoBank, in a recent outlook statement. “Faced with the enormous challenge of a post-property bubble environment and years of infrastructure over-investments, at least China has rhetorically faced up to its challenges and declared the need to reconfigure its economy.” The coming quarter is, says Jakobsen, “a key testing ground in Asia. Will China be able to execute on its declared intention to boost consumption, reduce over-investment and still be able to grow in aggregate?”
Questions like these are exorcising fund managers trying to work out how to position themselves. “The main local issue we are grappling with is China: what the transition in power there means for policy, and the transition of the economy to a lower growth trajectory driven more by consumption,” says Swan. He is positive on China, thinking these transitions will be made successfully. But “there are a lot of investors in America and Europe who think China won’t make this transition. They are heavily shorted in property and bank stocks, because those will be the first sectors that fall over if there’s a problem. There are enough reasons to understand why Chinese equities look cheap.”
Set against that, “China doesn’t need the same rates of growth it had historically, because it doesn’t have the same additions to the workforce that it has had in the last five years,” says Swan. “The working population will peak in this five year plan.”
India is no easier – and that country’s problems are also a big worry for global growth, because they make it even harder to sustain than it already was. “India is one of the most difficult markets to work out the direction of,” says Swan. “The Chinese make a decision and follow through; in India they haven’t been able to do so because of the nature of the government there. It is facing some real challenges: too many subsidies in the system, inflation proving sticky, and policy is very uncertain.”
While individual Asian countries present different challenges, the sure-fire sectors investors used to favour are changing too. “When China was growing the way it used to be, commodities were an obvious choice in that environment,” says Swan. “Going forward you need to be more selective about which commodities you own.” Blackrock is now looking more at the consumer space. “Consumer stocks are more cheaply valued now than three to five years ago.” And there is room for growth, there and in other more nascent industries: the services sector accounts for 45% of GDP in Asia compared to numbers in the 70s in developed markets.
So the tension continues: short-term vulnerability to external shocks versus excellent long-term fundamentals. The longer the timeframe, the better things look. “Our starting point today is very cheap PEs and below average price to books,” says Swan. “That’s always a good starting point for making long term returns in Asia.”
SIDEBAR: Blaming the State
As Asia has continued to carry the can for the world economically but has disappointed its stock market investors, analysts in the region have tried to look for underlying reasons for the disparity in performance. One popular theory is that Asia – and emerging markets generally – are impeded by the high proportion of local indices made up of state-controlled entities.
Morgan Stanley undertook a study of 122 index constituents with a more than 30% level of state ownership and debunked the theory; since 2001 (or since 2008 if you prefer) the state-held companies have significantly outperformed. If anything, this sector of the market represents particular value: those companies show a 12% premium in return on equity to the rest of the market, have a higher dividend yield, yet a trailing 12-month P/E of just 7.9 times. “While it is true that in some cases the interests of governments and minority investors may not be aligned, many of these companies are crucial to the economic success of their country,” says Jonathan Garner, an analyst at Morgan Stanley. “Moreover, state-controlled companies can benefit from factors such as state guarantees to obtain credit, access to resources, specific budgetary allocations, taxation benefits and regulatory exemptions.”
