The world has changed dramatically over the past three months. An Anglo-Saxon financial crisis has turned into an economic crisis of global proportions. It is hardly any time since the idea of economic “decoupling” was in the ascendancy, but proponents of that theory have been discredited as the herd has thundered to the far-too-narrow exit, causing Asian equities to slump.
The reality is that the fourth-largest economy in the world, China, is slowing, and that the world is “coupled” after all. This has been apparent for some time, especially given the fact that exports account for 36% of China’s GDP. Other harbingers of the slowdown were above-trend growth in Chinese residential investment spending and monetary tightening measures.
As in previous economic slowdowns, it is the weakest links in the chain that are exposed. The shift from widely available to unavailable credit has hurt global trade and it is clear that global commodity supply has moved from deficit to surplus in the face of slumping demand, just as new capacity comes on after long lead times.
One index epitomises these forces – the Baltic Dry index, which measures the price of moving raw materials by sea. The index has plummeted by almost 93% and is languishing at about 850, compared with the 3,000-4,000 level that is needed for a shipper to cover cash costs. This is after globally co-ordinated interest rate cuts and the announcement of a Rmb4 trillion (£390 billion) fiscal stimulus package in China. This economic adjustment and the policy responses to it are critical changes for the investment climate.
Also critical are the corrections in currencies and asset markets. Currency shifts have been enormous, and the implications for competitive advantage are significant. Imagine how Japanese exporters feel after a 40-50% appreciation of the yen against the euro and sterling, and how Korean exporters will feel after a 55% decline in the won.
Equity markets have, of course, adjusted violently too. According to the Datastream Pacific ex Japan index, we are in the second-worst bear market (a fall of 65%) since the index was launched in 1973. Such falls turn uncertainty into fear, and when fear becomes prevalent investors sometimes fail to observe the vital changes. Some may feel that valuation is a beacon in the fog of uncertainty and fear and that Asian equities are once again cheap. One simple metric to judge by is price-to-book value. Asian equities trade at 1.3 times book value (lower than 2001, but still above the low of 1997, which was 1.1 times). With the global economic slowdown still gathering pace and broadening out, valuation in the short term may not prove a reliable signal – though on a multi-year view expected real returns are starting to look more attractive.
Despite still being cautious on Asia overall, some stocks may offer better value than the market. A lot has changed for individual companies over the past few months.
The continuing lack of credit availability suggests that this is a time to invest in the survivors of an economic recession, for there will be many companies that fail or emerge weakened by the downturn. Others will prosper because their financial strength and their ability to invest through the cycle will benefit their product offering. Technology companies such as Samsung Electronics and Taiwan Semiconductor are in this category, as well as Shandong Weigao, China’s top supplier of disposable medical products.
Ultimately the pro-growth actions of governments and monetary authorities will work to the benefit of so-called early-cycle stocks, such as those in the consumer discretionary sector. Government policies have plenty of room to encourage domestic demand to offset the sharp slowing in exports and investment spending, the leaders in the last cycle. Examples include Esprit, a clothing wholesaler and retailer gaining market share with its unique product offering and strong balance sheet, and BEC World, a Thai television broadcaster with growing audience share.
The collapse in company valuations has created a rich set of stocks with low price-to-book ratios. This is a good hunting ground because investors have low expectations for profitability, so small positive changes to fundamentals can have an outsized impact on share prices.
Shinhan Financials, one of Korea’s best-managed financial groups, is trading on 0.8 times book with a normalised return on equity of 14-15%. The shares imply a capital writedown that is unlikely. Pacific Basin Shipping, a bulk shipper with a strong, proactive management, trades on 0.5 times book. Net cash on the balance sheet is $600m (£390m), which puts it in a strong position to make value-enhancing acquisitions. Profits should rebound sharply when trade flows become normal again.
Just as important as the stocks to buy are the stocks to avoid. In this category are many commodity-related companies. The change here is that Chinese exporters are experiencing shrinking margins (weak end demand and currency strength) and residential investment in China is slowing sharply. The phenomenal growth rate in floor space over the past five years (25-30% each year) has created an inventory overhang. Infrastructure spending by local government will also be constrained by deflating land prices (up to 40% of their budgets have been funded by land sales) despite the Rmb4 trillion fiscal stimulus package. It seems inevitable that commodity demand will slow for a lengthy period.
Investors with the courage to invest in Asian equities during the global slowdown need to take into account the importance of certain changes. More attractive valuations may offer a longer-term signal but can be misleading over shorter horizons. Global policy responses through monetary easing and fiscal spending will enable the region’s economic growth rate to reassert itself at a considerable premium to developed economies for decades to come. A year ago, Asian equities were overvalued; it is time to search in the rubble of the collapse for the winning stocks of the next 10 years.