Investors cut exposure to Asia Pacific excluding Japan as the global downturn hits everywhere. China still dominates the region but its trade links with Australia makes the latter a good prospect.
East Asian markets have been at the forefront of the volatility and deep readjustments that have blighted global markets since last year. The argument that emerging economies were sufficiently independent to decouple from western markets’ pain was muddled by overexcited commentators who failed to distinguish the economies from their traded markets. Unsurprisingly, the result is that exposures to China and Hong Kong have fallen in the Investment Management Association (IMA) Asia Pacific excluding Japan sector, and Australian and Taiwanese allocations have surged.
Many commentators supposed that current account surpluses and currency reserves meant increased independence that would decouple emerging economies from the West. The jury is still out. Their trade flows and economic growth depend much less on the West than they did, but globalisation ties everyone together in new and more varied ways. The reality is that emerging markets were always globalised enough to share the pain of their neighbours or developed markets – witness the peso, “tequila”, baht and rouble crises over the past 20 years. This provides a cushion from problems that will help for a finite period – emerging markets now feed off each other’s success too, regardless of stronger fiscal foundations or doing less business with the West.
One should note that the emerging market decoupling debate revolves primarily around “real” economic activity – the production and sale of goods or services domestically or across borders. This is different from the valuation of equity stakes in the real economy and separate from the effect on equity prices of investment or speculation. Many had not sufficiently made that distinction. Equity risk premia – the extra return for taking on the risks of holding equities versus holding bonds – fluctuate fairly widely over time. Research also shows that volatility in equity markets has always been far beyond what would be considered rational or plausible on fair valuation terms. Valuations that can be sky-high on the basis of hope can the next day be the calling card of an impending bear market.
In short, economies reflect what is happening in the real world, while equity markets reflect overexcitement, doom-mongering and guesswork about what earnings are doing just now – before the next results come out – and what they will do tomorrow. And markets can be wrong for long periods, even profitably. To partially or fully accept the idea of emerging economy decoupling thus has little bearing on the medium-term prospects of the funds that invest their markets.
The Shanghai exchange’s price/earnings (P/E) ratio was in the 50s over the turn of the year. Put into perspective, the FTSE 100’s P/E ratio hit 31.8 at the height of the dotcom bubble. Although the Nasdaq 100 did reach a P/E of 92.2, a comparison with the FTSE is more reasonable in that they are both broad market indices. Even though China is an emerging market, a P/E of 50 is high enough by any historical measure to result in highly-strung volatility. And so it has. Highly valued markets tend to see their shocks to the downside valued punishingly. From its peak of 6,092 in October 2007, the Shanghai Composite index has collapsed by more than half to 2,900 in the closing days of July. The Hang Seng index has also fallen sharply by almost a third, from 31,638 in October to 23,087 at the time of writing.
China became expensive. This fall from grace has meant that the exposures of Asia Pacific excluding Japan funds, have shifted in balance since the start of the year, according to June’s Lipper Portfolio Holding Analysis Report. This year started with a substantial 38.5 percent average allocation to greater China, which encompasses the mainland and Hong Kong. This allocation has been ground down by 4.7 percent.
Taiwan holdings saw a relatively large jump to 13.1 percent, a gain of 2.4 percent. Despite the Taiwan Stock Exchange index falling from 384 to 281 since October, the general thawing of relations with China has provided much optimism that is yielding results – the first half of 2008 saw record levels of trade and investment between the two. Australia was the other gainer of portfolio share, now constituting 22 percent of funds’ positions, up 2.8 percent.
Australia is a developed market with Anglo Saxon strengths and weaknesses, blessed by commodity resources that fuel the rate of global and regional growth. It was never as overvalued as many of its emerging market neighbours. From a high of 6,853 in November to 5,188 at the time of writing, the Australian All Ordinaries index has fallen less steeply than Shanghai. Long-term commodity exports appear assured, but medium-term commodity price pressure will dictate how this pans out month to month.
This column has previously reflected on the implications of the fundamental differences between fund holdings in the IMA Asia Pacific excluding Japan sector. Some funds were explicitly China funds and others were so overweight greater China that they were basically China funds in all but name. Excluding the China funds from July’s Lipper Asset Allocation Analysis Report on the sector, we can still see substantial differences between China exposures. These range from the Melchior Pan Asian Advantage fund’s 39.6 percent holding in China and Hong Kong, to the Lloyd George Developed Asia fund’s 13.3 percent – over 2008 they generated losses of 19.53 percent and 14.95 percent respectively. Others were more diversified and some that gave Australia credible weight in asset allocations. Swip Asia Pacific’s 64 percent stake is an example of a fund with a heavy Australian bias, resulting in 10.5 percent loss in 2008.
China is dominant in the sector and will remain a leading destination for fund investments. But diversification of a fund’s holdings is worth considering when selecting funds. China’s problems centre on the continued risk of overheating and inflation, and Australia’s commodity exporting businesses makes it a net beneficiary. More managers that must invest in the region will see Australia as an alternative for diversification in South-East Asian portfolios.