Roll with the punches
My daughters and I study Aikido and were recently practising our falling technique (ukemi), when our sensei stopped the class to remind us: first, don’t panic or freeze when being attacked; second, get out of the direct line of attack and use your opponent’s energy against him; and third, roll with the fall, getting back on your feet quickly, positioned for whatever comes next. Maybe I’ve been slammed on to the mat one time too many, but my sense is that the same advice applies to investing, especially during volatile periods like the one we’ve just witnessed.
Since 27 February, investors’ attention has been focused on handling the Asia-led fall in equity markets and positioning for what comes next. They have taken a few blows recently, leaving many wondering if this is the right time to move significantly down the risk curve, retreating from their Asian equities positions. Market pundits have advanced several reasons to justify such capitulation:
n a US housing-led train wreck is inevitable and “when America coughs, Asia catches a cold”;
n at year five, the Asian equity bull market is already long in the tooth and a bear market is seriously overdue;
n valuations are the most expensive they’ve been in over seven years and many Asian markets are, for the first time in a decade, trading at a premium to developed markets; and
n after four months of strong flows into emerging market equities, the last week of February witnessed a net equity capital withdrawal much more violent than last May’s, suggesting that flows may have inflected and may no longer constitute such a powerful tailwind.
While the above arguments are understandable and defensible, in our view recent volatility represents a garden variety bull market correction and the fundamental case for Asian equities remains undiminished, although this may be an opportune time to switch from momentum plays into some of the more defensive, laggard markets. The rest of this article recaps Asia’s strong fundamentals, notes how overbought the momentum-driven markets have become and makes a case for laggard markets.
First, Asian top-line growth prospects remain terrific, with consensus forecasting real GDP growth over the next two years of 7% (which is twice the global average and three times that expected for Japan and Europe). Strong top-line growth plus moderate margin expansion drives earnings growth forecasts for Asia of 12% over the next two years (versus 6-8% for the US and Europe). Additionally, earnings revisions remain supportive, with 53% of total estimate changes being positive in the four weeks ended 9 March (Europe, at 55%, was the only region with a higher percentage of upgrades).
Second, in most Asian economies real interest rates are low and inflationary pressures remarkably well contained. This suggests that overall interest rates are headed lower, which augurs well for further multiple expansion.
Next, Asian currencies are cheap, ranging from being slightly (South Korea, India) to moderately (Malaysia, Philippines, Taiwan, Thailand, Hong Kong) to massively (China, Singapore, Indonesia) undervalued. Weak currencies, by spurring exports and reinforcing stimulative monetary policy, often herald pronounced equity market performance. For investors based outside the region, currencies are an additional return kicker, as we expect that a basket of Asian currencies will outperform the US dollar by 8-10% a year over the medium term.
Finally, Asian equity markets trade on a forward PER of 14x which is reasonable, especially taking into account their strong growth prospects, low rates and weak currencies. However, within the region there is great dispersion, with neutral valuations in Singapore, the Philippines and Indonesia (all trading on 14-15x), cheap valuations in Taiwan, Korea and Thailand (12x, 10x and 8x, respectively) and several expensive markets such as Shanghai, India and Hong Kong (36x, 20x and 19x, respectively), and Vietnam.
When major structural changes occur it is in the nature of markets to exaggerate their short-term impact but to understate their long-term consequences (eg, Japan in the late 1980s, tech in the late 1990s, China and India today). Extraordinary structural changes, accompanied by excessive liquidity (as undoubtedly exists in China) and highly uncertain earnings stream projections create a breeding ground for herding behaviour and momentum- driven markets, with current examples including China, Vietnam and India.
Shanghai is up 40% over the past three months, trades on a forward PER of 36x and, even after its recent fall, is 45% above its 200-day MA. Vietnam possesses similar, but somewhat scarier statistics being, for example, up 64% over the past three months. While there are some fundamental reasons for this spectacular performance (eg, Vietnam’s entry to the WTO), it is important to remember two points:
n a “normal” equity market return is about 8% and, if you are lucky enough to earn substantially more than this for any length of time, get nervous and think very seriously about taking profits; and
n if Vietnam was a stock, it would be a volatile, high-beta small cap (Vietnam’s GDP is about 0.5% of the US’s).
Less extreme examples of momentum-driven markets include India (three years of supercharged growth are now threatened by a rising current account deficit, accelerating inflation and policy tightening) and Hong Kong.
Three Asian equity markets stand out as having lagged behind over the past 12 months. First is Taiwan, which trades on a PER of 12x in spite of consensus expecting double digit earnings growth in each of the next two years, sub-2% interest rates and the cheap Taiwan dollar. Second, Korea possesses a PER of 10x and a solid earnings outlook (like Taiwan, consensus expects double-digit earnings growth in both 2007 and 2008). Finally, the Thai equity market has been hammered for well- known reasons, but is now priced at a bargain basement PER of 8x, has had negative performance over the past three, six and 12 months, and is one of the few markets globally that is trading below its 200-day MA. There are reasons to believe an inflection point is nigh: Thailand’s central bank has been cutting its policy rate, domestic CPI is declining, capital controls have been loosened somewhat and the baht is undervalued. With moderately better policies and an improved domestic economy, Thai equities could conceivably double in value over the next two years.
Rotating into laggard markets is always challenging, both intellectually and emotionally, primarily because it is a contrarian strategy and timing can be crucial. We have found that identifying specific signposts or potential catalysts can be helpful, which could include factors such as:
n improved earnings revisions or a stronger yen for Korean equities;
n an improvement in new ISM orders or global semiconductor shipments for Taiwan; and
n new capital market policies, as well as evidence that economic growth and earnings revisions are holding up well in Thailand.
In our view the fundamental case for Asian equities remains undiminished, although this is likely to be a good opportunity to switch from overbought momentum plays into some of the more defensive, laggard markets. If the recent bout of volatility persists I’ll try to remain cognisant of my sensei’s advice, ready for whatever is about to happen next.
Kevin Hebner is macro strategist at Third Wave Global Investors based in Greenwich, Connecticut