Following a choppy start to the year for markets globally, Deutsche Bank's Asia strategist, Brad Jones, says institutional investors should monitor a potentially large increase in regional credit growth, credit-tightening measures in China and somewhat frothy asset valuations when evaluating their exposure to potential market volatility.
It has been a mixed start to the year for equity and credit markets. What is your view on holding risk in Asia?
We think investors should maintain exposure to risk in Asia, but position portfolios for future volatility. Global macro risks remain and the cyclical environment is likely to become more problematic later this year and into 2011.
Specifically, we see five key macro themes that will dominate Asian markets this year -- some of which have already made an impact.
The first relates to credit growth, which remains weak in Asia, outside of China. Asian banks maintain healthy balance sheets and excess reserves, however we think a sharp rise in credit growth from current levels could cause asset valuations to overheat.
Conversely, policy tightening in China has had an impact on local and global equities as investors digest the effects of a pull-back in Chinese stimulus measures. We expect policy tightening to continue this year, which could lead to further periods of market volatility.
Another theme is the seductive, though misleading, lure of 'decoupling'. We would urge investors not to get carried away with thoughts of Asian growth becoming de-correlated to demand in the US and Europe. This is particularly true for Hong Kong, Korea, Taiwan, Singapore, Thailand and Malaysia.
We expect the cyclical nature of Asian markets to remain, particularly in a year with the push-pull effects of Chinese policy tightening, a rebound in US growth, growing sovereign credit risk, and rising interest rates.
Finally, the need to find cost-efficient ways to hedge against potentially higher levels of volatility has become much more apparent in our view. As spreads compressed and volatility eased in 2009, protecting against market downside has become cheaper. We are increasingly active with helping our helping our institutional clients find efficient hedges to their portfolios.
To what extent will a rebound in Asian credit growth impact asset valuations?
Valuations are relatively benign at present, with Asian equities currently trading on a price to book ratio of around two times -- only slightly above the historical average. In the past, Asian equities have gone on to produce average one-year returns of 10-15% from these levels.
However it is important to note that credit growth in Asia, with the exception of China, remains weak despite regional M1 money supply growth rising at a record pace. Given the robust nature of Asian bank balance sheets, excess reserves and already low real interest rates -- which are likely to fall further in 1H-2010 as inflation picks up -- there is the possibility that broader credit growth could take off and drive regional markets to inflated levels.
Historical data shows that buying Asian equities when at a 2.2x price to book ratio (a comparison of book value to market price) has resulted in negative returns on a six month, one-year and two-year basis.
Markets have already reacted quite strongly to China raising the reserve rate requirements for banks -- how do you see credit tightening measures developing?
We expect Chinese banks to frontload a large share (possibly as much as 40% to 50%) of annual loan growth into the first three to four months of 2010, though a repeat of 2009's full year loan growth, which was equal to around 30% of GDP, is unlikely.
Concerns over continued property price increases, along with food prices (which together comprise almost half of China's Consumer Price Inflation index), are starting to lead to tighter policy measures, such as the recent 75bps rise in the reserve requirement ratio.
This is expected to help manage inflation in China and slow the rapid growth in asset valuations seen during the past 12 months. However, we expect further tightening measures coming into place this year to protect against the possibility of an increase in inflation (to 5% by mid-year in China) and non-performing loans.
We have to be somewhat careful of what we wish for in Asia. The rebound in growth has been so strong it has started to invite some degree of frothiness in some sectors and countries. The policy tightening that will follow will likely help to place a cap on asset valuations in 2010.
I know you just warned of the lure of decoupling, but given China's immunity to the global recession, is it time we started to think of Asia as decoupling from economic growth in the US and Europe?
We would caution against getting carried away with the decoupling thesis for a couple of main reasons.
First, we have found that about 80% of the variation in Asian equity returns can be explained by macro factors other than regional GDP or earnings growth (namely the US dollar, S&P500 and money supply). Note Asian equity markets have become more, not less, correlated to the US during the past decade.
Second, while some Asian countries, notably India, Indonesia and China (thanks to its stimulus programme) managed to escape technical recession, the majority of economies in the region are still highly correlated to economic growth trends in the US and Europe. This is particularly true of the 'Asia 6' (Hong Kong, Korea, Taiwan, Singapore, Thailand and Malaysia).
In the near-term, this is good news for these countries and Asia's highly operationally levered markets in general as Deutsche Bank expects US GDP to rebound by 3.6% in 2010.
We expect Asia to remain heavily reliant on external demand for some time yet, though on a longer-term basis, we are quietly encouraged by gradual steps towards the development of social safety nets and financial liberalisation across the region, most notably in China. These are critical steps in the long path toward internal rebalancing with a heavier reliance on private consumption growth.
How do you expect Asian equity markets to behave this year?
While headline GDP numbers in the region can make for pleasant reading, it is important for investors not to gloss over the intensely cyclical nature of Asian equity markets.
Given the scale of the region's socio-economic transformation in the past couple of decades, the buy-and-hold strategy has not been kind to regional equity investors. We expect the intense cyclicality of Asian markets to persist until a number of factors change.
Specifically, regional exchange rates need to be allowed to be driven more by market forces than by central bank intervention, which would give countries more control of domestic policy settings and thereby reduce the scope for boom/bust cycles.
Domestic demand and particularly services need to take over the baton from external demand as the key driver of economic activity.
Domestic financial institutions also need to comprise a larger share of overall trading volumes for local equity markets, which are currently dominated by relatively unstable retail and foreign flows.
Given we do not expect much progress in the next couple of years on any of these fronts, we continue to advise clients to protect portfolios against future volatility.
Where do you see the greatest opportunities in terms of regional asset allocation?
On a tactical basis, we favour the export driven markets of Japan, Taiwan, Korea and Singapore up until mid-year, which we expect will benefit from currently favourable valuations and an expected increase in export demand from the US. Meanwhile the structural re-rating in Indonesia should continue, with all asset classes -- equities, bonds and the currency -- likely to continue to appeal to foreign investors.
With policy tightening and bank recapitilisations on the way, the Chinese market is likely to underperform in the coming months. India is also not cheap and vulnerable to policy tightening in coming months.
We prefer equities with high real yields, such as regional telecommunications and possibly Reit stocks in Australia and Singapore, to investment grade credit, which while still generating modest returns, is not expected to match the out-performance witnessed in 2009.
Stocks with exposure to rising agriculture prices (ie fertilizer producers and equipment makers) are well-placed heading into 2010 in our view, as supply bottlenecks are beginning to resurface and given soft commodities dramatically underperformed the metals and energy sectors in 2009, should benefit from some rotational inflows this year.
On a longer-term basis, we expect Asian financials to outperform their US counterparts, largely on the basis that they trade at the same 2010 PE multiples and yet Asian financials have a vastly superior core growth profile. They also do not have the same regulatory or NPL overhang confronting their US counterparts.
In FX, the Indonesian rupiah looks attractive on the basis of its structural re-rating, high carry, improving balance of payments position and exposure to rising commodity prices. We also have a constructive view on the Korean won, which on its metrics is the most undervalued in the region, remaining well off its 2007 highs (nearly 40% vs. the Japanese yen for instance). We see the won as offering reasonable carry and particularly levered to the strong rebound in export growth.
