Asian economies emerged from August’s volatility in remarkably good shape. Growth rates are steady, valuations are realistic and many local firms have escaped the worst of the subprime crisis.
These are interesting times in the Asia Pacific region. Subprime and fears of the emergence of an equity bubble in China have already tested investors’ nerves in recent months, apparently presenting the region with its biggest challenge since the Asian financial crisis 10 years ago. What is going on?
Although August was one of the most volatile months for a long time, the impression of declining values may have run ahead of fact. At their trough, markets were off about 14% from their July highs; however, by month end the index was only down about 4% (month-on-month).
I do not believe the credit problems have gone away but neither are they as grave for the region as they first appeared. That is not because the problems should be under-estimated – losses of at least $100 billion to $150 billion (£49 billion to £73 billion) cannot be harmlessly worked through the financial system without some kind of growth scare – but because Asia has changed. Economies here are in good shape. Growth rates have been revised up this year, even as America slows – it has been decelerating since 2004. China’s exports expanded 34% year-on-year in July versus 28% for the year-to-date, while Korea’s exports expanded 20% year-on-year in July versus 15% for the year-to-date. At the same time, America accounted for just 10% of the growth year-to-date in China and Korea’s exports.
Outwardly that would appear to scotch the idea that China is just recycling exports from the rest of the region to meet American demand. But I would be wary of overstatement. Too much of China’s growth is low value-added, and is dependent on artificially low costs, from energy through to credit. That means raging growth now, but as with any misallocation of resources it spells problems later. Wait till the Olympics are over.
Turning then to India, that other engine of growth, there are reasons for optimism. India is the most closed economy in the region and the most reliant on domestic demand. The central bank has done a decent job of targeting asset prices as well as inflation. Consumers are still spending. India’s weakness is its lack of foreign direct investment and reliance on portfolio inflows. Its software sector is vulnerable to any protectionist backlash or outsourcing fatigue.
These two emerging economies matter most because investment there is driving demand in the rest of the region. As it is, savings rates are high, domestic interest rates are low and balance sheets are in good shape – household and government. Should it be required, there is plenty of scope for counter-cyclical spending if it comes to that: the shortage of energy, port capacity, highways and so on is a constraint on growth nearly everywhere.
The only area I see as vulnerable in the near-term is the asset reflation story. The top end of the market, particularly residential real estate, has been driven by speculation fed by globally cheap money. With risk repriced, expect some froth to blow off and less trickle down effect, too, with a consequent effect on the consumer. However in the long term, housing-led investment will reflect the larger story of rising real wealth.
What about stocks? Asian markets staged a swift rebound from their August lows, with several indices reaching fresh record highs, but volatility has returned more recently. Buying appears to be momentum-led and increasingly divorced from underlying fundamentals, noticeably in China, which is exhibiting signs of a bubble. We regard mainland shares as unattractive because of their poor quality, low transparency and earnings growth which in many cases depends on companies themselves investing in the market. The bursting of the bubble, when it happens, will be nasty.
For reasons of access, earnings’ predictability, valuation and regulation, Hong Kong stocks are superior (to mainland counterparts). Reflecting investor interest in China, Hong Kong markets have also done well, notably red chips and mainland industrial growth proxies.
But the outperformers are cyclical and narrow, for example, in metals. We find more comfort in names such as Rio Tinto in Australia and, within H shares, PetroChina. Other good steady cash flow firms include China Mobile and Hong Kong companies like Swire Pacific, Wing Hang Bank and Hang Lung.
Elsewhere, the Korean stockmarket has been driven higher by heavy industries, such as steel companies and shipbuilders. We remain wary of the quality of these cyclical businesses, finding higher quality within a firm like Samsung, which has languished, partly on concerns over the continued strength in the local currency.
India is a market that, by contrast, has the advantage of breadth and depth of companies and profit focus. While it has become expensive, earnings continue to surprise on the upside. Hero Honda and Grasim may appear stodgy in the context of racier stocks, but their strong balance sheets and market positions provide reassurance. The likes of Reliance Industries or Larsen & Toubro, both index favourites, continue to be bid up. The strong rupee, meanwhile, has affected the software sector but the major participants look fundamentally strong.
In terms of real fundamentals, overall Asia’s earnings growth is bobbing along at about 10%, according to our conservative forecasts. Valuations are not outlandish. Few local companies have been affected by subprime directly and most banks lacked the sophistication to invest.
The obvious trading call would be to buy defensives and utilities with good yields. For those who make the distinction between value and growth, value may be preferred. Near-term profits could be under pressure – among exporters especially. But there is little amiss in Asia in itself, either in companies or economies. My instinct is not to change a thing and just to buy more of what we like when markets fall.