ASIAN EQUITIES: Wild is the wind

Asian equities are presenting an unexpected conundrum for many investors.

Asia remains the fastest growing region of the world; it boasts emerging corporate champions, promising demographics and a burgeoning middle class. Yet last year the region’s stock market performance was the worst of any major market worldwide – including Europe, the epicentre of global financial malaise.

Why? And when will Asia’s role as the engine of the world economy be reflected in share price performance?

At the heart of this apparent contradiction is the nature of international capital’s behaviour towards risk. The notion that money would continue to flow into emerging market assets regardless of the West’s fortunes was thrown into sharp relief by the 2008 financial crisis – developing world financial markets were hit disproportionately hard following the collapse of Lehman Brothers.

Since then, the explosion of global financial risks – principally continued western banking sector weakness and sovereign debt burdens in rich countries – has created a backdrop of volatility that has done little to bolster a sure-fire case for emerging markets.

When investors get the jitters, capital has tended to flee emerging markets in favour of safe haven assets, most commonly US Treasuries. Conversely when bullish sentiment prevails, emerging market assets have often been the beneficiaries.

KNOCK-ON EFFECTS

The past year demonstrates this clearly: as fears over the eurozone crisis exploded in the second half of 2011, Asian equities suffered outflows of $13.4 billion for the year, but as sentiment improved in the first three months of this year, the asset class saw inflows of $27 billion, according to HSBC. While Asia ex-Japan saw 25% declines in stock market values between April and October last year, the MSCI Asia index was up 14.6% in the first quarter of 2012.

Although it might at first blush seem irrational that capital should flee emerging markets during bouts of turbulence in the West, fund managers say that correlation across global financial markets means this dynamic is unlikely to change any time soon.

“If you look back, there is a very consistent history of the key driver of equity performance in the region being economic growth – and that is highly correlated to global growth,” says Andrew Swan, head of equities for Asia at Blackrock. “Anything that has the potential to impact global growth affects equities here. That’s why you see sell-offs when political issues arise in Holland or Spain which on the surface may seem totally irrelevant.”

Others agree. “Asian stocks, as always, remain vulnerable to shocks and market swings coming out of the US and Europe because of the impact on fund flows into the region and the vulnerability of Asian exports,” says Shane Oliver, chief investment officer at AMP Capital Investors. “If US and European shares experience another setback of the European crisis or global double-dip worries, then Asian shares will fall as well.”

Yet Asian equities are still appealing when judged on the basis of fundamentals. Forward price to earnings (P/E) ratios on Asian stocks are, on average, around 10 times, Oliver says, compared to 11 a year ago, suggesting good value. Korean shares, in particular, are cheap. Even in domestic China, often considered the flag-bearer for unreasonable valuations, today’s (historic) P/E of 12.7 times is dramatically below the long-term average of 32 times earnings.

In addition, the mindset of Asian central banks has changed: a year ago monetary authorities were tightening policy amid widespread concerns over inflation, particularly in India, Indonesia and China (where inflation eventually hit 6.5% mid-year). But now, says Oliver, “Inflation around the region has faded as a major concern, and central banks have eased up on the policy break.”

Moreover, the region’s long-term fundamentals – low debt, rising middle class, growing consumerism – have hardly gone away.

“Taken together, this all suggests gains in Asian shares over the year ahead, even though we may go through a further short-term rough patch or correction driven by concerns about Europe and the US,” adds Oliver.

More of a challenge is interpreting whether low valuations are justified or represent good value. On this, Swan is broadly positive: “Our central view is that the LTRO [long-term refinancing operations] in Europe has given central bankers time to come up with solutions: a muddle through scenario. Under that scenario, and without contagion, Asian equities do look good,” he says. “Asian equities are trading at a PE [price-to-earnings ratio] around the trough level, and at 1.7 times price to book. They’re already discounting a lot of bad news there.”

Such sanguine views on Asian equities are not universally shared, however. Ajay Kapur, strategist at Deutsche Bank thinks the heyday of Asia’s stock markets is over.

“We believe the potential underperformance of Asian equity markets versus developed markets could last for years,” he says. This does not mean these markets will perform badly – the Deutsche Bank house view is “moderately positive” – but that they will no longer outperform developed markets.

“The risk-love advantage that Asian equities enjoyed is gone,” he says.

Even if valuations are historically low in Asia, they’re lower elsewhere, he says. “Earnings-per-share expectations for the US and Europe have now dropped to exceptionally low levels, while in Asia, these estimates are no longer low but quite punchy,” says Kapur.

Other reasons include excess capex eroding EBIT (earnings before interest or taxes) margins in Asia and “only nascent brand power”.

MIXED FORTUNES

Asia is not a homogeneous market. In India, for example, the economy is now threatened by the prospect of a downgrade to junk bond status from Standard & Poor’s while it wrestles with its fiscal deficit, debt burden, political gridlock and a growing vulnerability to external portfolio equity flows (and therefore external shocks).

In contrast, Indonesia’s markets have been galvanized by the nation’s upgrade to investment grade and remain insulated by the strength of the domestic economy. In the Philippines, too, the discussion is of a potential upgrade, while in Taiwan it’s largely about realising the potential of cross-straits relations and working out how a gradual US recovery will affect the electronics sector.

But for Asia, the focus ultimately reverts to China. “In Asia, the critical question is China,” says Steen Jakobsen, chief economist for SaxoBank, in a recent report. “Faced with the enormous challenge of a post-property bubble environment and years of infrastructure over-investments, at least China has rhetorically faced up to its challenges and declared the need to reconfigure its economy.”

He notes that the coming quarter is “a key testing ground in Asia. Will China be able to execute on its declared intention to boost consumption, reduce over-investment and still be able to grow in aggregate?”

Such questions are exercising fund managers trying to work out how to position their portfolios.

Swan says the main local issue is what this year’s power transition in China – a new generation of leaders is slated to take the reins in Beijing in the coming months – will mean for policy and for the task of reorienting the economy to a lower growth paradigm, driven increasingly by domestic consumption.

Although Swan believes this year’s political transition will be successful, he says there are nevertheless “a lot of investors in America and Europe who think China won’t make this transition.

“They are heavily shorted in property and bank stocks, because those will be the first sectors that fall over if there’s a problem. There are enough reasons to understand why Chinese equities look cheap.”

While individual Asian countries present different challenges, the dependable sectors previously favoured by investors are also changing. “When China was growing the way it used to, commodities were an obvious choice,” says Swan. “Going forward you need to be more selective about which commodities you own.”

Blackrock, for one, is looking more at the consumer space. “Consumer stocks are more cheaply valued now than three to five years ago,” says Swan. There is room for growth in this and other more nascent industries: the services sector accounts for 45% of GDP in Asia compared to numbers in the 70s in developed markets.

Whatever the case, for now the tension continues between the region’s short-term vulnerability to external shocks and robust longer-term fundamentals. But over the longer term, things start to look up, Swan says.

“Our starting point today is very cheap PEs and below average price to books,” he says. “That’s always a good starting point for making long-term returns in Asia.”