AFR: Are asset bubbles growing in Asia?

Australian Financial Review, Smart Money, November 2010

At the G20 meeting in Seoul last week, most discussion was about the US’s latest bout of quantitative easing and its impact on capital flows. And although all this has started in the States, it’s in emerging markets like Asia that the effect is likely to be most keenly felt – and it won’t be entirely positive.

“Capital is likely to continue to pour into the emerging markets as interest rates remain low in the west,” says Keith Wade, chief economist and strategist at Schroders in London. “Quantitative easing in the US will give an extra push to this in coming months, creating the risk of a bubble in both emerging market equities and treasury bonds,” he says.

Wade is not alone in talking about bubbles. In fact, economists in Asia have been worrying about them for the best part of a year now. Mainly, the concern is about particular segments of Asian economies – Chinese real estate being the main one – whereas people have tended to view emerging market stock markets as expensive, but not prohibitively so. The worry is that QE2, as the latest US policy has become known, will tip those markets over the edge from expensive to bubble territory.

This matters to Australians more than it used to. It has never been easier for Australians to invest in emerging markets than it is today. Fund researcher Morningstar tracks 45 different emerging market funds, and a further 40 investing in ex-Japan Asia, although some of these are structural variations of the same fund. And they are growing: the Platinum Asia Fund alone has A$3.87 billion under management. ishares, with its range of exchange-traded funds that represent an index but can be bought or sold like a share, has made it even easier to get exposure to emerging markets; its MSCI Emerging Markets index ETF has A$49.6 billion in net assets (although naturally only a small proportion of that is sourced from Australia), and its China ETF A$8.6 billion. And there are a host of structured products that appear from time to time, linked to movements in Asia, BRIC economies (Brazil, Russia, India and China) or a single country, usually China or India.

Morningstar’s Phillip Gray estimates that Australian assets for emerging market unlisted managed funds have gone from about A$4.43 billion on October 31 2005 to A$12.25 billion five years later – a near trebling. And that doesn’t count the ETFs.

Australians have so far been doing rather well out of the rebound in emerging market assets. The T Rowe Price Asia ex-Japan Fund has returned 22.43% in the year to October 31, and the Aberdeen Asian Opportunities Fund 21.03%; funds from Colonial First State, Perennial, BT, Fidelity and AMP are all over 15% to the good. Some broader emerging market funds have done even better: the Colonial First State Global Emerging Markets Sustainability fund is up 25.35% in the last 12 months, and the Aberdeen Emerging Opportunities Fund 23.85%. Here, products by Arrowstreet, Lazard, Macquarie, Dimensional and GMO are also more than 15% ahead. Lazard’s Emerging Markets Fund has managed a remarkably 16.75% return per year over the last seven years.

But all fund managers are warily looking at valuations and wondering if it is time to worry. India’s stock market is on a price/earnings ratio of 24.5 times, on ThomsonReuters’ calculations, and Indonesia 21.6 times.

Citi, for example, has been advising its ultra-wealthy private banking clients that emerging market equities still look well placed, but that there will be better times to buy. “Most of the effects of monetary easing are likely to be felt in the emerging world, and China not least,” says Richard Cookson, chief investment officer within Citi’s private banking arm. “Since the Fed is likely to continue to do what it takes, more money is likely to flood into emerging assets. Commodities, emerging equities and currencies are all likely to rise further.” But he has concerns too. “We just think that positioning is so extreme that the risk of disappointment and setbacks in the short term is high.”

Cookson says there have been three waves of investor appetite for emerging assets since the last 1970s, “and we are now in the fourth. Each successive peak has been bigger than the last, and the present one will probably be no exception.” That creates a challenge of timing: it suggests there is a fair way to run before a reversal, but that one will probably come in time. It’s just a question of when.

For Australian investors who have put money into Chinese shares, there’s a lot to consider. It’s true that the Chinese market is up 30% in the last few months, but it’s also true that it lagged most of the rest of the world before that. AMP Capital Investors chief investment officer Shane Oliver addressed the subject in a note this week. “Our assessment is that, after a possible brief pause following recent strong gains, Chinese shares are likely to have more upside,” he said. “Valuations for Chinese shares are still attractive,” with a price to (historical) earnings ratio of 22 times compared to a long term average of 34, he argues. It should also be pointed out that in some other celebrated markets, valuations are nothing like as high: ThomsonReuters says the P/E ratio of the Russian market is just 9.4 times, and Brazil’s, 12 times. Hong Kong (15.4) and Singapore (16.9) are not far out of step with Australia (14.7 times).

One sure sign that Asian governments and central banks are worried is the fact that capital controls, which had long been considered a sign of a backward and limited economy, are back under discussion. “Suddenly, after years in the intellectual deep freeze, capital controls have acquired a new aura of respectability,” notes HSBC economist Stephen King. “Even the IMF, which in the past has regarded capital controls as the devil incarnate, is now prepared to accept that such controls have their uses.”

So far Brazil (by increasing taxes on inflows into bonds) and Thailand (a capital withholding tax on government bonds) have already implemented some controls while Korea and Indonesia (which has already imposed a minimum holding period for central bank bills, which one could argue is a capital control) appear likely to be next. China, of course, has no need to impose capital controls – it already has plenty of them. The idea of capital controls is to keep check on the flows of money coming in and out, and in particular to try to regulate the type of money that comes in and out, limiting short-term speculative capital that can cause a lot of trouble when it goes.

Still, most measures so far, and those expected to follow, have not imposed capital controls on equities. Historically, those are rare, though not unheard of, particularly in Latin America. So there is not likely to be much impact on the way that emerging market equities funds available in Australia can invest or repatriate their gains.

Instead, one of the things Asian economies are trying to keep a handle on is their currencies. They have not forgotten the Asian financial crisis in 1997-8, when sudden withdrawals of money drastically reduced the value of their currencies, starting in Thailand, which kicked off the whole crisis. All Asian economies are on a far stronger footing these days, but at the same time they are very worried about rising currencies, for two reasons: firstly because it makes their exports uncompetitive, and secondly because they’ve seen what happens when a flood of money changes direction and goes out again.

This is also something Australian investors need to keep in mind, because if their investments are unhedged, then movements in the currency will affect them. So far, the Australian dollar has been rising just as fast as Asian currencies, and in many cases faster still; but if Asian governments are successful in bringing the values of their currencies down against the US dollar, then from an Aussie investor’s perspective, that’s bad news.

BOX: How Australians can get Asia exposure

Emerging market mutual funds

These tend to invest in emerging markets worldwide, usually following the MSCI Emerging Markets index as a rough guide to country allocations. That means heavy exposure to Asia, and some to Eastern Europe and Latin America, but very little to Africa (bar South Africa) and the Middle East.

BRIC funds

Some funds invest in the four countries of the famous BRIC acronym: Brazil, Russia, India, China.

Asia ex-Japan funds

Many funds decide to focus on Asia, leaving out the developed economy of Japan, but keeping in well-developed Asian economies like Singapore, Hong Kong, Korea and Taiwan.

Country-specific funds

Several funds invest exclusively in Chinese stocks (though usually not listed in China itself, but in Hong Kong), and some do the same for India

Exchange-traded funds

iShares offers exchanged-traded funds – which represent an index but trade on the stock exchange in Australia like any other share – over emerging markets, Asia, the BRIC economies, Hong Kong, Singapore, China, Taiwan and South Korea. There are also some listed investment companies, such as AMP’s for mainland Chinese stocks

Structured products

These appear frequently, offering a return linked to the performance of a market like China, Asia or BRICs. Usually they do not invest directly in those countries but seek to replicate performance through derivatives.