17 August 2011 FinanceAsia
Recent price action has been brutal. Exactly what have Asia’s equity markets priced in?
It’s been a difficult few weeks, and Asia’s equity markets have finally started singing from the same ‘growth negative’ hymn sheet, long voiced by the region’s more cautious local currency bond markets.
Thus, in a relatively short space of time, Asian equity markets have migrated aggressively from pricing in a soft patch in developed markets, to a slowdown, to a recession. The ensuing re-pricing has been vicious, with the fall in equity markets from August 4 through August 11 being, by my reckoning, the biggest six-day sell-off since the MSCI Asia ex-Japan was launched in January 1989.
At about minus 1.5% standard deviations below the mean, trailing valuations are at levels last seen during the Lehman crisis, Sars and the Asia Crisis. In other words, markets are pricing an economic slowdown similar to some of the most difficult periods in the region’s recent financial history.
For those that believe growth will recover in the second half of 2011, evidently the sell-off represents an outstanding buying opportunity. We have met with a number of clients with such views and quite reasonably, they point out that the consensus economic forecasts still remain positive for 2011 and 2012, and that as yet; there has been no economic data print that confirms a recession is underway.
Conversely, there are clients that believe the US and core Europe are facing difficult headwinds, possibly recessionary, and that Asia’s markets are accurately pricing in the prospect of substantially weaker economic activity. This group are comfortable sitting on the sidelines, unwilling to catch a falling knife, and waiting for signs of the market to bottom.
Regardless of which camp investors prefer — as the Lehman situation showed us only too well — volatility can generate unintended economic consequences to the extent it negatively impacts sentiment and expectations.
Well, for example, negative sentiment pushes down the share price of Bank X, let’s say, to the extent that its solvency is questioned, thereby further affecting sentiment towards the financial sector, and further embedding the negative growth loop. The consequences can be even more dangerous and dramatic as the onset of a classic economic recession.
No better was this evident than following the failure of Lehman Brothers on September 15, 2008. Until that day, financial assets were reasonably well correlated and reasonably stable. At the point Lehman filed for Chapter 11 protection, however, markets collapsed and economies followed soon after.
So if global growth were to slip into recession, how would Asia fare?
In the event global output were to contract — caused either by organically slowing growth or triggered by event risk such as a sovereign and/or corporate default — Asia would not escape unscathed; indeed, it would probably be hit disproportionately harder in the initial stages as its typically smaller, more responsive economies (and high beta risk assets) rapidly adjusted to the new growth outlook.
However, we suggest to clients that Asia should be able to withstand the worst of the global economic downdraft, for the following reasons:
One, steady growth in local domestic demand both insulates and cushions the region from volatilities in developed markets. Indeed, the proportion of Asia’s exports to the US/European community has been steadily declining since 2000 and, as of mid-2011, accounted for a fifth of total exports. We expect this trend to continue as intra-regional trade slowly but surely takes hold.
Two, in much the same way it did in 2008, the sharp fall in global growth expectations will likely lead to lower commodity prices. And lower commodity prices should provide central banks with additional flexibility to cut rates given the historically close relationship between inflation and oil prices. While growth will decelerate from current levels, nevertheless, the key point here is that lower interest rates should additionally support Asia’s terms of trade and thus profit margins.
Three, lower commodity prices should further improve the degree of policy flexibility Asian governments and central banks already enjoy — certainly when compared to their counterparts in the west. China, for example, has raised rates five times since October 2010 and could just as easily lower them — although whether that would be the correct course of action is open to question. And although Asia’s average debt metrics are somewhat higher than pre-Lehman levels and interest rates lower, nevertheless, authorities still have room to cut interest rates, ease bank reserve requirements, and/or roll out targeted stimulative spending packages as necessary.
Finally, as the latest round of quarterly earnings make clear, Asian banks are in good health, with strong levels of liquidity, capital and asset quality. For example, Asian banks have negligible exposure to European peripheral debt and should be able to weather the prospect of a second financial crisis in the same way they did the US subprime crisis. Importantly, net loan-deposit ratios remain under 100% for every banking sector in the region (even Korea), which means they are not exposed to volatile wholesale markets for funding purposes.
But while Asia might be better able resist the worst effects of a global financial crisis (GFC) part two; it would be a mistake to assume it would emerge entirely undamaged from the experience. China, for example, is still dealing with the consequences of its first post-GFC stimulus package, which in 2008 was equivalent to more than twice the size of the US’s quantitative easing programme as a proportion of GDP.
Among other things, these consequences include still-rising non-performing loans in the banking system due to the unfettered lending binge, occasional food riots, a property bubble and 10 months of interest-rates hikes required to combat inflation — which (in year-on-year terms) has still yet to peak.
For all these sorts of reasons, a recession in developed markets is precisely not what China — or Asia — needs at the moment. And while they have the reserves and surpluses to deal with it today, it will inevitably come at a future cost — possibly to materialise in the form of impaired credit metrics.
What is your near-term view towards the markets? How are you positioned?
While corporate performance, specifically profits, almost always drive markets over the long term, headline macro uncertainties tend prevail over the near to medium term. And so it remains today. In fact, while eurozone solvency and US growth risks rightly dominate Asia’s investor perceptions, local earnings growth remains okay.
For example, although only 55% of the MXASJ [the MSCI AC Asia ex-Japan index] have reported second-quarter 2011 earnings, 63% of companies have exceeded analyst expectations — the highest ‘beat ratio’ recorded over the past 21 quarters, save the third quarter of 2009. And this compares to an average beat ratio of 52% since the second quarter of 2006.
On reasonably strong earnings and almost zero price appreciation since January 2010, the MXASJ’s trailing price-to-earnings ratio is now 11.5 times. As I mentioned, only during the Asia Crisis in 1998 and the Lehman Crisis in 2008 has the measure been lower. Note the index’s 35-year median is 16 times.
Similar valuations are reflected in 10-year cyclically adjusted price-to-earnings ratios (Capes) which are at or close to their historical medians. In particular, Capes in north Asian markets continue to display lower average valuations than those of the south.
So for the reasons I articulate, we are underweight Asia ex-Japan equities and have been so since mid-May. Within the equity complex we are overweight north Asia and have exposure to the defensive sectors.
Despite dramatic, recent price declines, we are not ready to adjust our underweight. A reasonable amount of bad news has been priced into equity valuations — nevertheless, until we get clarity on the soft patch-versus-recession debate, we remain defensive.
And away from equities, how are you positioned towards bonds?
In fact, the macro developments described may be regarded as positive for Asia’s domestic debt market; for the following reasons:
Firstly, moderating inflation and a likely shift to a neutral monetary policy — precipitated by slowing growth — suggests a stable to positive yield outlook. For example, the central banks of both Indonesia and Korea recently delayed their decision to hike rates during August to the fourth quarter of 2011 and possibly beyond. I’m guessing we’ll get more of these on-hold type decisions across Asia going forward.
Secondly, the recent use of exchange-rate appreciation as a monetary tool supports currency stability (if not currency gains). Indeed, Asia’s currency complex is proving resilient — the J.P. Morgan ADXY Index barely moved throughout the equity sell-down in August. However, my sense is that export and commodity currencies will remain under pressure (Australian dollar, New Zealand dollar, won) while domestically oriented currencies will generally out-perform (baht, Indian rupee, Malaysian ringgit).
Lastly, low levels of interest rates in developed markets underscore Asia’s superior carry profile of approximately 4%.
Thus, we continue to highlight Asia’s local currency bonds as an important part of a diversified portfolio. It is our view that among Asia’s publicly traded securities, the asset class displays an attractive risk-adjusted return profile, comparing well to the type of return metrics posted by global commodity, fixed income and equity markets.
And finally, what is your advice to clients now?
In these volatile times we continue to recommend clients concentrate on our core investment themes: portfolio diversity, correctly valued investment opportunities and an on-going quest for yield.
Most importantly, focus your core portfolio on yield: local currency bonds, US dollar-denominated high-grade fixed income, income-oriented mutual funds and dividend stocks with a preference for defensive sectors.
Try to find assets at the right price. In addition to Asia’s generous dividend yield stocks, we also like stocks with outright cheap valuations, particularly those in the following sectors: consumer staples, consumer discretionary, utilities, telecoms and healthcare. As I suggest above, we continue to prefer the more defensive markets of north Asia.
Long-short hedge funds should also perform well in these markets. We suggest a switch into those names in step with market moves, while staying sufficiently flexible to respond to changing dynamics. We would also observe that, over the past six weeks, Asian hedge funds have done a reasonable job of protecting downside risk while generating alpha across asset classes.
Finally, trading markets are still in a range which we suggest playing — particularly the FX market. I continue to recommend clients diversify their portfolio into a mix of currencies.