Dec 2009-Jan 2010

ASIA: the new normal

Should inflation and low growth in the West mean that every portfolio should have Asia at its core for the next few years? By Nick Fitzpatrick
barcode.jpgInflation in the US and Europe is not a certainty just yet – that will depend on the outcome of the quantitative easing process by governments, and the jury is still out on that one. However, if inflation does result, Asian equities may offer a useful hedge against eroding wealth as the cost of living increases.

The case for investing in Asian markets over the past decade always centred on what was happening in Asia itself: growth. While Europe and America were ticking along smoothly, Asia merely represented a place for risk takers to seek a little excess return.

Now, the downturn in Western economies provides yet more impetus to look eastwards. It is no longer a case of investing for attractive growth in Asia itself, but as 2009 draws to a close and sentiment remains dulled, it is also a case of actively investing away from sluggish Western countries and searching for yield.

This did not happen after the last major credit crunch that occurred in Asia in 1997 when Western investors did not have to traverse the Earth to find growth opportunities.

Wilfred Sit, chief investment officer for the Asia Pacific region at Mirae Asset Global Investments, says: “Asia started to recover in 2003. But the Western economies also did well from 2003-07 due to over leverage.” With Western economies doing well, investors had no need to diversify into Asia.

He adds: “After this latest crisis, however, there is no support for growth in the West and Asia is now a more obvious destination.”

He points out that there is still a lot of investment to be made in the region. The US still accounts for 40% of the MSCI World index, with Asia Pacific ex-Japan being just above 10%, and this includes China.

Search for yield
In their current search for yield, investors have pretty much exhausted their opportunities in close-to-home markets, like corporate bonds. Property remains a conundrum and commodities may already be bubbling too much.

The Asian consumer, meanwhile, is expected by a number of fund managers to lead the global recovery. Asia’s ability to administer first aid at present is down to the fact that it has little to recover from. It was not immune to the banking crisis but did not suffer the most savage effects of it.

All this means that Asia is now likely to be a beneficiary of the West’s pain.

Anatole Kaletsky, an economic commentator for The Times and cofounder of GaveKal Research, is an inflation sceptic but acknowledges that there are many who feel that the pumping of money into economies by governments through quantitative easing may well lead to a steep increase in prices. For those who fear inflation and fear also that Western equities will not temper the erosion of wealth that inflation causes, Asia will offer a useful inflation hedge, he says.

“The best hedge against domestic inflation is to invest not in gold or oil, but in this region of the world [Asia],” Kaletsky said. He added: “If you want a buy-and-hold equity strategy have it in Asia, not here. If you want a tactical strategy then use OECD countries with Asia at the core.”

Kaletsky was speaking at a London event focused on investment opportunities in Asia. Jonathan Schiessl, head of the Asia Pacific desk at Ashburton, a South African-owned fund manager that organised the event, revealed that he had positioned portfolios to gain exposure mainly to Chinese and Indian consumer stocks, followed by banks and infrastructure.

Schiessl’s position reflects the belief that Asian consumers, who are not burdened by debts unlike their Western counterparts, will lead the world out of the downturn – but as they spend, they may also purchase far more goods from their own domestic and regional companies than from importers.

Similarly, Kaletsky says: “China knows it has to keep its economy growing by 8% a year. If China cannot do this through
exports – and it will not – it will have to do it through domestic consumption. This also applies to Asia.”

So he and Schiessl expect Asian exporters to turn their goods and services towards their domestic markets as their customers in the West cut back on spending and worry about unemployment. These firms are also far less leveraged than their Western competitors following years of tighter financial discipline after Asia’s own leverage binge in the 1990s that preceded the credit crunch there in 1997.

Henry Chan, head of Asia Pacific Investment at Baring Asset Management, says: “Asia had its financial crisis ten years ago and it has seen a great improvement in corporate returns as a result of the corporate discipline lessons that were learnt.

“Indonesia, the Philippines and Thailand all weathered the recent storm a lot better. Their strong balance sheets will support domestic demand.”

If these companies can now squeeze decent margins out of their burgeoning domestic businesses, then Asian equities should find a lot to support them.

For this scenario to play out, though, Asian consumers have to spend and Asian companies need to translate that spending into profitability – and none of this is a given.

Saving for a rainy day
Richard Sennitt, a fund manager in Asian equities at Schroders, says: “The attractiveness of Asia is that Asian consumers, like the corporate sector, do not have to restructure their balance sheet. However, the flipside to all this is that savings rates are so high. This is because Asia lacks the social safety nets that we have in the West, like pensions, meaning there is a huge incentive to save more.”

Investment as a percentage of GDP in Asia has been rising in recent years, yet consumption has been going down, says Sennitt. This needs to be rebalanced and Sennitt thinks this will happen. Asia cannot just keep selling more and more cheap goods to the West, he says. However, the increase in spending will be a longer-term development.

“We assume that over time, as more and more people enter the workplace and earn more, there will be more disposable income.”

Robin Creswell, principal at Payden & Rygel, says: “In Asia there is low or zero personal indebtedness – but mechanisms need to be in place to allow personal consumption to take off, and I think it likely this will happen.”

Kaletsky says the Chinese authorities are determined to reduce the level of savings in their country’s banks. But how can China and other Asian countries do this? Revaluing the currencies could help.

Peter Lucas, investment strategist at RBC Wealth Management, says: “If Asia wants to encourage domestic consumption, Asian countries have to give their consumers something of value to spend with.”

Stronger currencies would help consumers afford imported goods produced by intra-Asian and other trade, for example. However, many of Asia’s currencies are pegged to the dollar, which is weak. As is always the case with currency pegging, it essentially means that the ills of the reference-currency country will be imported to the pegged country. In other words, inflation in the US could be imported to Asia.

“What Asia does next will be crucial,” says Lucas. “Will it keep its currencies pegged to the dollar, letting inflation get out of control, resulting in current account deficits and a boom-and-bust cycle? Or will Asian countries decouple from the West and revalue their currencies to foster domestic consumption?”

He adds: “If China revalues its currency it will head off the inflation threat and make the growth cycle more sustainable.”
China has been under intense pressure to revalue its currency. The US, for one, thinks the move would help US exporters and rebalance global trade. Asia has been the main producing block in recent years.

Lost in translation
Stimulating demand, then, is crucial if the Asian consumer really is to lead the world into recovery, but for Asian equities to benefit, and particularly if they are to serve as a useful inflation hedge, then Asian companies have to translate consumer spending into profitability.

Creswell, at Payden & Rygel, says: “There is a lot of history that says stock prices do not cyclically follow economic growth.

There have been periods in the last 20 years where emerging market economies have been strong but equity prices have not grown rapidly.

“The question is: will Asian companies get the margins?”

He notes that Asian firms are further challenged by increased input costs such as rising commodity prices and, potentially, upward pressure on wages if disillusioned workers drift back to the hinterlands, or if they become more militant.

There is also the question of how companies will handle capital inflows of hot money.

Creswell says: “Financial governance and regulation in Asia are generally impediments to the efficient allocation of capital there, but as long as financial infrastructure develops at the same pace as investment, then the right environment is being created.”

Niall Paul, chief investment officer for equities at Aviva Investors, says the advent of capital controls in Asia has been an important development.

“Policy makers in Asia learnt the lessons taught them ten years ago: they do not want to see speculative capital wreaking havoc with exchange rates again. I anticipate more proactive counter-cyclical policy moves by central bankers to control capital flows in future and Asia has intervened in currency markets to prevent rapid appreciation of its exchange rates.”
He also says that long-term investors

need not fear these moves, which should establish a more sustainable outlook for economic growth.

Paul adds that the danger of investing in emerging markets like those in Asia, and in growth companies generally, is the way these companies reinvest for future growth. China has developed a problem with overcapacity in its industries, he notes.

He points out, though, that Thailand, Korea and Taiwan have world-leading companies in certain sectors.

West looks East
Western companies are likely to turn their sights to Asia also. Revalued Asian currencies would help them, but weaker balance sheets will not. Although many Western companies have found markets in Asia, their shares are arguably not a good play on Asian growth. Investing in US blue chips is the same as investing in US consumer stocks, says Kaletski.

Hervé Lievore, an investment strategist at Axa Investment Managers, says: “The most dynamic market for [car manufacturer] GM now is China, not the developed world, but the problem [for Western firms] is how to sell to these markets. It is very difficult for Western brands to gain access. Often, they have to partner with a local player and this weighs on profit margins.”

Western companies are facing strong competition from their Asian peers, which are not weakened by leverage. This competition, in the short term at least, is even playing out beyond Asia where Western firms, which are weakened by leverage, are in some cases losing market share to Asian rivals.

One company to watch is Texwinca Holdings, a Hong Kong-based textile manufacturer. In its 2009 interim report, although it noted that orders from the US were unstable and expansion continued to focus on mainland China, it also noted that it had benefited from consolidation in its industry.

Sennitt, at Schroders, says: “We can find opportunities in certain stocks that are more dependent on what is going on in the global environment, such as Hong Kong industries that have markets in the West and that have gained market share from competitors that have gone bust. Some of these companies still look pretty cheap.”

Inflation fears
Fund managers, chief investment officers and strategists clearly see more reasons coming out of 2009 to invest in Asia, not just for Asia’s sake any longer, but also because of the global situation.

They do not all say that inflation is a certainty – “We do not believe that inflation in general will pick up that quickly,” says Chan, at Barings – and even if they did, Asian equities would not be the first choice as a hedge for all of them. Axa’s Lievore suggests equities linked to commodities with a bias to small and medium cap oil and energy, while Creswell, at Payden & Rygel, is offering an inflation product backed by G7 bonds.

Tristan Hanson, Ashburton’s manager of asset allocation and strategy, says: “We have to be careful about what people mean by inflation. Core inflation measures like CPI strip out food and energy and this is likely to decline. But headline inflation includes commodity prices, which are rising, and this may well grow quite quickly in the near term.

“Asian equities should do well in the long run. In the short term, if inflation were to increase in the West, that would probably mean higher interest rate expectations and potentially a stronger dollar, which is quite negative for Asian equities, but it doesn’t affect the longer term picture.”

However, Kaletsky, the economic commentator, says there are widespread fears of inflation. “Personally I do not think that inflation will accelerate in the US, Britain or Europe in the next three to five years, simply because there is so
much unemployment and excess capacity. That is also what the central banks believe at present.

“However, I recognise that many other people disagree. There are widespread fears of inflation in the markets because of the amount of money being printed by central banks and these fears could well intensify in the next year or two if quantitative easing is not fully reversed and interest rates remain at or near zero, which I think they will.

“Asian equities should be a good hedge against these fears of domestic inflation, even if inflation does not actually materialise.”

©2009 Funds Europe

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