Overview
What is going on in Asia? Stock markets in the region have fallen much more than those in developed markets, and yet economic growth remains fairly robust. Only countries whose economies have always been dependent on the West have seen growth rates falling sharply. Elsewhere, continued high growth gets explained by the decoupling theory that posits that Asian economies are no longer dependent on US demand, having reached the point where they can rely on each other. But if this is the case, why have stock markets fallen so much?
"Policymakers are also now intervening to prop up currencies"
First, the falls must be considered in the context of how regional markets had performed not only last year but since 2003. Over the years the bull market had built up so much momentum that once reality hit home, as it did by November, the markets were particularly vulnerable to a sell-off.
Second, we suspect that Asian economies have not in fact decoupled as some believe and that weak growth in the developed world will eventually have a serious impact on growth in the region – it’s just taking some time to show up. We are entering the second year of the crisis and we have yet to see recession in any of the Western economies. Why?
Thus far, the crisis has been limited to the financial sector and has taken time to feed through to real final demand. Central banks have been concerned with shoring up banking systems, with a certain degree of success. However, there is a link between the financial sector and the real economy: housing and mortgages. House prices had risen at unsustainable rates for many years as a result of loose monetary conditions. Now they are falling. Consumers have been hit in three ways: they may have borrowed more than their homes are worth; banks are not lending so new buyers are not emerging; and their spending power falls.
Third, in addition to the shock caused by the credit crisis, we have also had the shock of rising commodity prices, notably oil and gasoline. The reasons for the rise are complex, but the effects are obvious. Like falling house prices, rising gas prices make people feel poorer. As a result, spending falls, resulting in falling revenues for companies, setting off job losses, and leading to further cuts in spending – a vicious spiral of the worst kind.
Fourth, the sharp falls in stock markets likely indicate that Asian economies are far more vulnerable to rising inflation than their Western counterparts. Food and energy bills account for a high proportion of household expenditure. Belt tightening thus has a more severe impact here on final demand.
What’s next?
One should be mindful, then, that things may worsen before they get better. Economic growth is being constrained. This would typically lead to a lowering of interest rates. Yet in Asia the aforementioned inflationary pressures are causing social unrest in Indonesia, Malaysia and Thailand.
The hope on this front is that with the world economy slowing, these pressures will start to wane. But the turnaround is not yet in sight. The responses of Asian central banks reveal the quandary they are in. Some have raised interest rates to cope with inflation; others have increased reserve requirement ratios and implemented stricter lending controls. On top of that, policymakers are also now intervening to prop up currencies as a means to reduce imported inflation, a reversal of the trend seen 12 months ago. But on balance monetary policy appears excessively loose with real interest rates negative across the region.
Despite these problems we are not bearish towards Asian stock markets. Recent earnings releases have been satisfactory. Admittedly, rising input costs are expected to squeeze profit margins, especially with the export slowdown. Companies that have expanded too fast and those that did so with borrowed money are vulnerable. But over time this “weeding out” will provide the stronger companies with opportunities to strengthen their businesses further, buying assets at distressed prices and filling gaps left by those unable to expand.
So the opportunity we see is on a 3-5 year view, with corporate activity picking up as valuations fall. Indeed, bargain hunters should reap rewards from the slump. We are already seeing very reasonable prices. Prudent investors who follow the fundamental principle of buying decent companies cheaply should feel more confident now – although prices have yet to reach distressed levels. Meanwhile, the reasons to feel bullish on Asian economies remain: once commodity and other bottlenecks are addressed, the push for wealth in China and India, as well as numerous other emerging markets, will drive not only their own economies but also those around them for decades to come.
Strategy
We like Singapore and Hong Kong; both share similar characteristics, being home to companies with strong balance sheets and conservative, transparent managements. In fact, we hold large positions in Singapore-listed companies; not because we are attracted to its economy, which is relatively small, but because of the regional and global reach of the companies listed there. In the case of Hong Kong, its companies have survived exceptionally difficult circumstances; they know how to manage their businesses and look after shareholders.
We also favour India because we have been able to find many well-managed companies, from IT to pharmaceuticals. India’s chaotic democracy tends to hold the country back at times, but many companies there have learnt to deal with this situation.
We are underweight in China, Korea and Taiwan. Despite the large market China represents, we prefer to gain exposure to the country through Hong Kong-listed firms that do business on the mainland. We have found it hard to find well-managed companies listed in China and also have concerns that the profits of mainland-listed firms may not be as real as they are made out to be.
Korean companies appear cheap on paper but we think they deserve to. Corporate governance remains a key issue for many Korean corporates, as well as for the Korean courts that rule on governance issues. In the case of Taiwan, at the moment we have neither been able to find good quality companies nor companies with reasonable valuations. Furthermore, the Taiwanese corporate sector is particularly dependent on demand from the US which, as mentioned earlier, will continue to slow.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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