A sharp rebound in global markets since late March has confounded even the most battle-hardened veterans of emerging market investment. While talk of late has increasingly cast the rally as a turning point in the global crisis, not everyone would agree.
By January, as markets appeared to bottom out, a belief had emerged among many analysts that dirt-cheap stocks and bonds would trigger a buying spree – especially for Asian assets.
Yet it wasn’t to be: asset prices continued to dive as most regional equity markets tumbled and local bonds posted negative or marginal returns. Not for the first time, markets had “failed to price in the fundamental deterioration in global conditions at the end of last year,” says Philip Poole, chief emerging market economist at HSBC. As a result, they were “surprised by the severity” of the crisis.
In recent weeks, a flurry of global initiatives has emerged to support developing economies – including the G20’s April commitment to boost the IMF’s resources as well as international trade finance – alongside some encouraging economic data. Meanwhile G7 central banks have taken unprecedented steps to increase the supply of credit and stabilize the international banking system.
At the time of writing, the emerging market asset class has outperformed its developed market peers: the FTSE Emerging Index has risen 27% compared with a rise of 21% for the S&P 500. Meanwhile, Asian currencies are beginning to stabilize while the recent thaw in global credit markets has allowed the likes of Indonesia and the Korean lender Hana Bank to launch large benchmark bonds at satisfactory pricing.
Not so fast
Yet although some investors may be dipping their toes back into risk markets, most are still licking last year’s wounds; even the most diversified Asian investors were hit hard by plummeting asset prices across the board. Mounting fund redemptions led to indiscriminate selling regardless of valuations or fundamentals of assets. Asia-Pacific hedge funds were the worst performing globally, with assets falling from over $190 billion to $122 billion by the end of the year, a decline of about 36%, according to research outfit Hedge Fund Intelligence.
Asian investment funds are traditionally more biased towards equity-focused strategies, a fact that has deepened their losses. As the global economy went into meltdown at the end of last year, the distinction blurred between domestic and external, as well as defensive and cyclical stocks, as corporate earnings and asset prices uniformly plunged.
The losses were historic: by the end of 2008, India’s Sensex had posted an annual decline of over 50% while Hong Kong had shed 48.3% and Vietnam, Asia’s worst performing market, plunged 66%. The FTSE Asia Pacific index dropped 43% last year – its worst annual loss on record.
Myths debunked
The wild swings in emerging market indices have undermined one of the key arguments for offshore investment: diversification value. Asian equity and, to a lesser extent, credit markets have been exposed as highly sensitive to developments in the West. In fact, by the end of the boom, global investment strategies had become more correlated than five years prior, according to a 2008 Citigroup study.
Says Jason Rogers, credit analyst at Barclays Capital: the region is “a production house for the world and so regional markets are more leveraged to sentiments towards the global economy”.
The global liquidity bubble effectively erased the valuation gap between emerging and developed market stocks, while some stocks traded at a premium to developed bourses – even though credit costs were greater in Asia. In addition, yield-hungry crossover investors, including many macro hedge funds, upped exposure to Asian assets by benchmarking global equity indices. Such strategies helped fuel bubbles in large-cap stocks, with some registering whopping 30 times price to earnings (P/E) ratios between 2006 and early 2007.
“This over-excitement in valuations highlights how investors priced in too quickly the fundamental long-term economic change that is happening in Asia,” says Harry Krensky, founder of Atlas Discovery Capital, an emerging markets hedge fund in New York.
The recent rally in Asian assets has been fuelled by a belief that today’s valuations are not reflective of fundamentals, and moreover, that forced capital repatriation by domestic and offshore investors over the past few months has simply aggravated the situation. The 12-month forward P/E ratio on the main MSCI Asia-Pacific Index hit 7.87 in November and has now risen to 12.56.
The China factor
Thanks largely to China’s impact, global emerging markets have outperformed this year. As a key driver for emerging market growth and the world’s third-largest economy, the country may be showing some tentative signs of economic recovery. The government’s aggressive $586 billion stimulus package – to be spent on housing, infrastructure and social services – drove industrial output to an annualized 8.4% in March, compared with a record low of 3.8% in the first two months of the year. Monetary easing has caused an expansion of Chinese M2 money supply, which is now 25% higher than a year ago – the fastest growth rate in 12 years.
According to a recent Merrill Lynch fund manager survey, which questions 214 equity investors with over $561 billion in assets worldwide, a net 26% of global portfolio managers say they are overweight the asset class, up from just 4% in March. As a result, some Asia-focused investors have cautiously nipped out of defensive stocks to hold shares in cyclical industries such as technology stocks.
In addition, the survey notes 22% are bucking the global trend as they are overweight Asian financial institutions. However, “there are no crowds in the Asean [Association of South-East Asian Nations] markets, with investors underweight Thailand, Philippines and Malaysia,” says Michael Hartnett, co-head of international investment strategy at Bank of America Securities-Merrill Lynch Research, due to concerns about the political climate in Thailand and Malaysia as well as regional illiquidity.
So far equity markets have been stronger beneficiaries of the recent spurt of global liquidity. Although the iTraxx Asia index – which represents credit protection for 50 investment-grade borrowers outside Japan – has tightened in the past month, it still stands at around 330bp compared with 200bp at the beginning of September. Meanwhile, the iTraxx Crossover index of non-investment grade developing Asia bonds is still 900bp compared with 300bp in September.
Credit markets
Some argue that Asian credit markets could outperform Asia equities. Chia-Liang Lian, a Singapore-based portfolio manager at Pimco, cites an extended period of low interest rates and low inflation in the region, unrealistically high implied default rates in bond prices, reduced fund redemptions and lower credit market volatility. In addition, the standard deviation of daily returns on Asian equities and high hedging costs will eat into risk-adjusted returns and could trigger outflows into bond funds.
“Lower growth is bad for equity markets so credit markets may benefit,” says Tim Condon, chief Asia economist at ING.
But a prolonged downturn could depress prices for pro-cyclical credits longer than markets are currently pricing in. “We have yet to witness the worst of the rating cycle for corporate credits in Asia,” says Lian. “Our focus is on sectors less susceptible to the cyclical swings, and companies with a track record of weathering previous downturns, and we are cautious on electronics, shipping and real estate.”
Analysts tip Indonesian external and local bonds now sovereign and corporate financing risks in the country have abated, as well as shorter-dated Korean bonds.
Over the past two months then, “the positive economic data from China has re-awakened investors to the strong structural growth stories in Asia,” says Brian Jackson, senior strategist at Royal Bank of Canada in Hong Kong. The emerging consensus is that bond prices will be supported by Asia’s stronger economic fundamentals since the regional crisis of 1997, with lower leverage and healthier current account balances, so the argument goes.
“Corporates have healthy balance sheet positions, reliable cash flows and improved risk management,” says Jack Lin, Hong Kong-based head of Janus Capital Asia. Rising urbanization and increased emerging market consumption will fuel demand for infrastructure, utilities and food, he argues. As a result, stocks and bonds are adjusting to the correction in global markets while strong growth potential in Asia’s real and financial economies will support asset prices in the medium to long term.
“It is worth noting that credit-to-GDP ratios in most Asian countries, including China, are low compared to developed countries,” says Pimco’s Lian.
Heart of the crisis
Yet the market optimism of the bull years was itself fuelled in part by a belief, now discredited, that the region’s economies would be relatively insulated from any downturn in the West. Despite massive fiscal and monetary stimulus across the region, the ADB expects Asian growth, excluding Japan, will slow to 3.4% this year compared with 6.3% in 2008, largely due to vanishing western demand for the region’s goods.
Singapore’s finance minister Tharman Shanmugaratnam reaffirms to Emerging Markets the widely held view that at the heart of the ongoing crisis is the “huge bubble that has burst in US consumption”. Large and persistent current account deficits in the US have been funded by excessive Asian, notably Chinese, savings – a fact that contributed to a period of low global interest rates; this in turn created conditions for abundant liquidity, which spurred excessive borrowing, indebtedness and asset bubbles in the West.
But the financial landscape has since changed beyond recognition, and the intrinsic value of assets globally must necessarily adjust to reflect the end of abundant liquidity, says HSBC’s Poole. “The destruction of real wealth has to be a part of the solution to this crisis, to bring the stock of assets back into line with the income streams that have to service them,” he says.
Appetite, not strategy
Some fear the recent market rally is at best indicative of a modest renewal of risk appetite rather than a strategic allocation for long-term gain.
“I thought Asia would be staging a much bigger recovery given the region’s strong fundamentals,” says Tim Condon, chief Asian economist at ING. “In this environment, Asia may fail to outperform other emerging regions, while in a year or so, assets from emerging Europe may attract more interest given the extra yield pick-up.”
A recovery in global demand remains key for Asia’s near-term prospects. But the medium-term fortune for Asian stocks and bonds ultimately depends upon whether domestic consumption in the region takes off.