Playing the long game in Asia

Current speculation about Asian markets provides little direction for prospective investors. Instead, they should adopt a long-term outlook, based on structural reforms, writes Evan Erlanson. 

At the start of 2014, a quick survey of market forecasts for the coming year, as represented by the 'research’ that floods inboxes at the beginning of each year, showed with few exceptions, most analysts and economists believed global markets would placidly follow the trends established in 2013. 

Three themes dominated predictions: 

1. There would be an ongoing recovery in global trade that would steadily improve the world’s economy 
2. China would achieve a soft economic landing by gradually reducing non-bank lending, hence avoiding a banking crisis 
3. Developed markets such as the US, Europe and Australia would continue to see their currencies outperform those of emerging markets in Latin America and Asia (with the notable exception of the Chinese Renminbi). 

Our general world view was, and remains, very different. 

On the first point, we expect global trade to stagnate, or even decline, over the medium term. As for the second point, we think investors would be wise to focus on all-weather investment themes rather than obsessing over the intentions of Beijing’s policy-makers. Finally, we do not see much value in forecasting the direction of Asian currencies because we do not see a robust connection between currency strength and equity market performance. 

Today’s investors in global markets face a constant onslaught of conflicting information. Smart money managers take an approach that ignores today’s headlines while working hard to figure out what themes will be grabbing headlines 12 months down the road. In the immortal words of Wayne Gretzky, “¨ skate to where the puck is going to be, not where it has been”. 

This approach has several merits. Firstly, it is difficult to outperform the average market investor if your information comes from identical mainstream sources. Secondly, by creating one’s own investment themes, you can truly deliver results that are different from the broad market. In the long run, being different from the market is the only way to consistently beat the market. 

Test those consensus calls from January 2014. Global trade? Still weak. Virtually all emerging market currencies have strengthened dramatically (except for the Renminbi, which has weakened). And China has not imploded financially, but the market is still down year-to-date. So much for following the consensus. 

Markets have behaved counterintuitively to date in 2014. From our vantage point in Hong Kong, one of the main factors differentiating market performance has been investors’ perception of a country’s 'political velocity’, a concept we have coined to express the speed and direction of policy movement. 

'Political velocity’ a driver for global markets 

Over the past two years, many nations have experienced increased political dissent, accompanied by deteriorating international relations. As a result, investors have rewarded those countries (and leaders) who are able to get the job done or, in the case of popular newly-elected leaders, appear to offer this possibility until proven otherwise. 

US and Europe—an active approach should begin to outperform 

A year ago, international markets were coasting. Many investors thought it safe to adopt the 'rising tide lifts all boats’ approach and invest passively in market indices. Today, investors require a more selective approach. 

In the US, the Federal Reserve Bank has been gradually 'tapering’ its stimulus package over the past six months. From its high of $85 billion per month, the Reserve has steadily reduced the pace of its purchases to $35 billion per month. In isolation, this would typically produce rising bond yields and depressed bond prices. However, after initially rising sharply to around 3 percent in September 2013, US 10-year yields have steadily declined (to around 2.5 percent), again defying consensus expectations. Meanwhile, the US stock market has made new record highs every month for the past 15 months, which reveals a surprising lack of concern over potential future rate increases. 

How can investors explain this apparent disconnect? And why has market volatility declined to levels not seen since 2007? One answer is that US stocks and bonds, despite their elevated prices, are still more attractive and liquid than global alternatives with similar risk profiles. Another is that success begets success: as the US market becomes larger in size (relative to other markets), passive asset allocation strategies must increase their US weighting. Finally, the US, for all its faults, has more political velocity than any other major developed market. 

Of course, this velocity is imperilled by the political obstructionism between Democrats and Republicans and within the parties themselves. Furthermore, while jobs and company profits have been improving, the overall economy took a backward step in the first quarter of 2014. Some market watchers now believe corporate earnings growth will slow as profit margins decline, and corporate share buybacks will also fall from elevated levels. 

These circumstances allow active investors to differentiate themselves. For example, the dramatic underperformance of small cap growth companies in the first five months of 2014 created excellent opportunities to buy solid long-term stories at beaten-up valuations. Technology and software companies continue to defy gravity despite very weak corporate spending, and could potentially benefit when fixed investment increases. 'Near-sourcing’, or the shift of production from far-flung Asian locations back to the US and Mexico, could also benefit US manufacturers. 

Across the Atlantic, political velocity is scant, but what little exists resides with the European Central Bank (ECB). Recently, the ECB adopted negative interest rates to incentivise banking institutions to deploy idle capital in the form of loans to companies and consumers. This and other aggressive moves by the ECB seem sufficient to encourage investors to continue ploughing funds into the European stock and bond markets, many of which (like the US) are at record highs. Our view of this is that investor positioning is now more one-sided and complacent than at any time since 2008. 

As a result, we expect a concentrated, active strategy to deliver a much more solid outcome, particularly if investors also consider the risks associated with events in Ukraine and the Middle East. 

Policy momentum is driving markets in Asia 

In Asia, where we focus our investment strategy, this year’s underperformers have included China (-4 percent), Japan (-7 percent), and Korea (-2 percent). In all these cases, there is a general impression of a loss of momentum, institutional inertia, and (particularly in the case of Korea) possible corruption and potential incompetence. 

It is truly surprising when events with few actual political or economic implications can completely change an entire country’s national mood, but the Sewol ferry disaster has done just that in Korea. Consumer confidence, housing starts and general business activity have all weakened considerably since the accident on 16 April. At the same time, criticism of the one-year-old Park Geun-hye administration has mounted, partly because of backsliding on campaign promises and partly due to its tendency to suppress challenges (including those posed by the families of Sewol victims) with armed force. 

Militarism and nationalism, too, are gaining momentum regionally in a way we have not observed since the 1970s. Our view is that nationalistic tendencies reflect heightened insecurity among the region’s elites, who are facing increased challenges to their legitimacy as economic tailwinds and foreign direct investment flows weaken. 

One country that recently appeared to be unexpectedly teetering between civilian and quasi-military rule is Indonesia. Having risen around 17 percent in the year to June 2014, the Indonesian stock market is one of the region’s top performers. This was driven largely by the expectation that Indonesian voters would elect as President the extremely popular Joko Widodo, who almost everyone knows as Jokowi. 

What complicated the story in the lead-up to the 9 July election was the surging popularity of Prabowo Subianto, the 'comeback kid’ of aspiring military dictators. This was largely due to Prabowo’s ability to secure the support of Indonesia’s Golkar party, but also reflects Indonesia’s latent nationalistic tendencies. Prabowo’s main point of differentiation appeared to be his emphasis on national security and protectionism, which strikes a chord with many Indonesians who are suffering from a weak currency and persistently high inflation. In addition, he promised to deliver 3,000 km of roads and 4,000 km of railways, which would be the most significant public infrastructure-related accomplishment of any Indonesian president since Suharto. 

Shortly after the election, both candidates claimed victory. The 'quick count’, which is released shortly after the election, showed Jokowi in front 52/48. But this didn’t stop Prabowo also declaring he had received “a mandate from the people”. In our view, the election of Prabowo would have weakened Indonesian democracy and undermine free market capitalism. 

In the short term, the election result has been very important for Indonesia’s economy and market. We believe the market fallout will yield some very interesting investment opportunities in the Indonesian consumer, manufacturing and infrastructure-related stocks we follow closely.  

Long-term trends favour emerging Asian markets 

Looking ahead, investors should understand the diversity of Asia. Without doubt, it possesses diverse sources of secular growth that are unmatched by any other geographical region. 

Even developed Asian markets such as Japan or Korea are home to companies that derive most of their income and growth from emerging markets and industries (think e-commerce, smartphones and biotech). Looking across the region, we currently see tremendous growth opportunities across Asian themes including online advertising, financial reform, the automotive supply chain, energy diversification and corporate productivity enhancement. 

Currently, emerging markets make up approximately nine per cent of the world’s equity market, but account for 52 per cent of the world’s population. From a secular standpoint, the growth potential is obvious and it is worth bearing in mind that Asia represents a larger demand pool of consumers and companies than all other emerging markets combined. 

In conclusion, we encourage prospective investors in Asian markets to look forward several years and think about where Asia’s 'puck’ is going to be at that time. In other words, try not to think of Asian markets in their current form. Instead, anticipate how they are likely to develop structurally over the next decade, and invest in companies and industries that are most likely to rise to the top. 

Such a strategy, we believe, can deliver the benefits of Asian growth and change even if the broader market does not perform well. 

Evan Erlanson is Chief Investment Officer, Seres Asset Management Limited, Hong Kong.