Evan Erlanson takes a look at the broader Asian market and identifies opportunities based on countries' economic orientation.
In recent years, Australians have come to accept Asian economic growth as a forgone conclusion.
According to many commentators, Asian demand for Australia’s natural resources will grow reliably and indefinitely, shielding Australia from global economic shocks.
Perhaps as a result, the concept of Asia as a superior investment opportunity has become almost mainstream.
Without a doubt, many Asian countries are experiencing high levels of growth and development that should last for the next two decades.
But at the same time, investors and their financial advisers must be aware of the complexity and variety of markets and economies and the different stages of the economic cycle, and actively manage exposure.
Diverse economies
From a high-level view, Hong Kong and Singapore are wealthy, services-driven entrepots while Japan and Korea are advanced but highly cyclical manufacturing-based economies.
Among emerging economies, China and India are experiencing rapid investment and consumption-led growth, while Indonesia and the Philippines have bootstrapped themselves back onto consumption-led growth trajectories.
Such differences need to be factored in when building portfolios, as risk and return vary significantly.
Domestically-oriented countries
In this category, we are looking at the Philippines and Indonesia. These are fundamentally strong economies with strong balance sheets – stronger than many countries currently rated AAA – but still rated junk by the major ratings agencies.
We believe there must be an upside here. Indonesia has run a current account surplus since 1998 and has foreign reserves of US$114 billion; the Philippines has run a current account surplus since 2002 and has foreign reserves of $76 billion.
Historically, these economies have consistently delivered 5 to 7 per cent of gross domestic product growth despite the global economic slowdown. Inflation is under control and financial and political health is better than in any time over the last century.
While the stock markets of these countries are moderately overvalued due to investor concentration in the larger and most liquid names, there are still some very interesting secular opportunities in consumer, property, financials, and resources.
Government has been conservative in public spending on infrastructure and a change would open up huge potential in the manufacturing and resource sectors.
Export-oriented countries
This includes Japan, Korea, Taiwan and Thailand. Japan and Thailand are arguably export/domestic hybrids as they have large domestic markets for fast-moving consumer goods, autos, consumer electronics, and service, but each of these markets is beholden to the global economic cycle and, increasingly, Chinese consumer demand and fixed capital formation.
All these economies are fundamentally healthy, with Korea the most sensitive to risk-off events and currency fluctuations.
However, the combination of slowing demand in Europe and the US and ongoing credit tightening in China is dragging on the export engines that power these economies.
Average year-on-year export growth has fallen from highs of 30 to 35 per cent in 2010, to 20 per cent in the second quarter of 2011, to roughly 15 per cent in September 2011.
Taiwan’s September export orders, for example, grew by just 2.7 per cent, due mainly to declining orders from Europe and Japan and lacklustre order growth in China.
We believe we are now three to four months away from the trough of the earnings downgrade cycle and are becoming very interested in cyclical sectors.
Investment-driven countries
In China, the market environment and stock prices have been driven almost entirely by fixed asset investment trends and government policy for the last three years.
As the developed world stalls again, Chinese stocks remain in thrall to domestic monetary and fiscal policy, which we expect to stay in tightening mode until well into 2012.
A hypothetical Euro-shock resulting in an effective appreciation of the Renminbi (RMB) against the Euro would likely force the government to consider another economic stimulus package. However we believe that:
- It will not repeat the heavily-criticised 2008 stimulus;
- It will avoid making long-term commitments on behalf of the next generation of leadership as it prepares to exit;
- The latitude for increased lending or fixed asset investment is circumscribed by inflationary pressures.
These tensions suggest that the government will tolerate more market “pain” – in the form of falling real estate and stock market value – than most expect, before stepping in to save the day.
However, the Chinese market is among the most attractively valued in the region and we believe those prepared to accept short-term volatility will enjoy outsized payoffs over a 12-18 month period. Industrials, financials and first-tier property developers will provide investors with attractive investment opportunities over the next two years.
Portfolio diversity
These economies and markets are very different in terms of structure, level of maturity, and potential.
This does have its advantages; for instance, creating automatic diversity within a portfolio. Compare this to Europe where most economies are mature and highly correlated due to history, regional politics, and financial linkages.
So Asia, while volatile at times, is a lower-risk long-term investment option than either Europe or the US.
Many Asian economies are less affected by issues such as European sovereign debt defaults and a potential US recession than current market valuations suggest, buffered by growing domestic demand, continued market share gains, and favourable demographics.
Asia isn’t fully immune from the economic and fiscal plight of OECD [Organisation for Economic Co-operation and Development] economies, as many Asian manufacturers are dependent on Western consumers, and near-term liquidity flows often cause a disconnect from fundamentals in Asian markets.
In the short term (three to six months), Asian equity valuations may thus be among those worst affected by a risk-off event triggered by European sovereign default, bank crises, or political fragmentation.
A significant and sudden Euro devaluation would cause resumed capital flight from emerging markets into havens such as Treasuries, US dollar, Japanese government bonds, and the Yen.
We can position for this by hedging Asian currency exposures, taking long positions in beneficiaries of a strong Yen, or by shorting commodity plays.
However, we expect any correction to be short term, offering a great opportunity to pick up Asian cyclical stocks and small to mid-cap stocks on the cheap.
So now is a particularly opportune entry point, considering the strength of the Australian dollar and low valuations in Asian markets. When risk appetite improves globally, investors will benefit not only from the underlying growth of Asian markets, but also from the normalisation of valuations and Asian currency appreciation.
Evan Erlanson is the chief investment officer of Seres Asset Management.
