In the coming quarter, we believe North Asia will continue to be the focus with positive news momentum, whereas South East Asian countries will experience further economic adjustments. The performance of regional markets will depend on the US 10-year bond yield and the US dollar, partly as a result of what the Federal Reserve (Fed) decides to do regarding tapering of its quantitative easing programme. A higher yield and stronger dollar will continue to exert pressure on the regional risk assets and, therefore, more net outflows will be expected. Otherwise, a stable bond yield and a softer dollar will give the regional markets greater breathing space to carry out much needed structural reforms.
In Japan, there are signs to show Abenomics is beginning to bear fruit with aggressive monetary reflation having a positive impact on the Japanese economy. The GDP (gross domestic product) growth for the period April to June was 3.8 per cent up on an annualized basis. Private consumption, export and public spending were the drivers of this growth. Money and loan growth has accelerated, consumer confidence has risen and the Tankan business survey has moved into positive territory. For the first time in many years, inflation expectations in Japan have risen to over 1 per cent. So long as the authorities keep reflating and expanding the Bank of Japan’s balance sheet, the Japanese yen will remain weak against the US dollar. As economic growth starts to improve, Prime Minister Abe is expected to take the decision to raise the consumption tax rate from 5 per cent to 8 per cent in April 2014. The Bank of Japan is expected to come up with further measures to balance the negative impact on the economy as a result of this hike in tax rates. No doubt the government’s target to improve the primary balance by cutting the deficit by 50 per cent in financial year 2015 is a challenging task. To sustain the economic recovery, Abe has to deliver his third arrow on how he wants to carry out the country’s structural reform.
The news that Tokyo has been selected as the venue for the Olympic Games in 2020 boosted market sentiment. What is more essential for the equity market, however, is the recovery of the corporate sector. Thanks to the economic recovery and earnings improvement, the corporate sector has seen a reduction in leverage and made progress on the net cash position. As a result, we expect corporate activities will pick up from here.
In China, there is a lot of skepticism regarding the economy, and the credit-crunch situation in June has increased bear sentiment in the market. The sharp increase in Shibor was not an indication of what happened in the subprime fallout in the US. Beijing has sent very strong signals to the market that it would like to address some of the structural problems in the economic system. Rather, the outbreak of the interbank liquidity crisis in June was indicative of a change within the new government toward credit expansion and economic growth at large. The authorities are concerned about the runaway growth of shadow banking activity and the rapid build-up in unsecured provincial government debt. The Chinese government is determined to bite the bullet to bear short-term pain for long-term gain. The task is undoubtedly very challenging as it requires finding the right balance between growth and risk. The Shibor crunch was engineered by the People’s Bank of China who wanted to send the message to state-owned banks of its own intentions to squeeze shadow activity.
President Xi Jinping recently argued that China should not focus on solely GDP growth, but should also pay attention to livelihood improvement, social progress, ecological benefits and effectiveness. This should help ease the pressure on provincial and municipal leaders to strive for GDP growth in their regions. In China, the key concerns have focused on the rapid surge in the credit and the ballooning shadow banking system. There is no question that a part of China’s domestic savings is misallocated, resulting in overcapacity in certain sectors and wasteful investment. Local government borrowing is also problematic. The Chinese government’s official estimate is that local government debt amounts to USD 2 trillion, or about 20 per cent of GDP. No doubt some trust companies will be forced to go under and some local governments will default on their liabilities. However, we do not believe there is a systemic crisis here. China saves close to 50 per cent of its output and its equity and fixed income markets are limited in scale. As a result, the large pool of domestic savings has to be allocated via banks and other forms of borrowing activity, leading to a high level of debt. In addition, the household sector in China is underleveraged and the same applies to the corporate sector. State-owned companies have been the main borrowers from banks. However, the country has run current account surpluses and the government sits on a large amount of reserve assets. While the risk has increased of seeing China experience slower growth in the coming years, as a result of its deleveraging process, we believe the Chinese government has enough tools to achieve a soft landing. It should also be pointed out that the Chinese banking system is relatively liquid, as nearly 40 per cent of the funds of Chinese banks go toward either the purchase of government bonds or to meet reserve needs. The loan-to-deposit ratio for the banking system is 75 per cent and there is a 20 per cent reserve requirement to be satisfied with the People’s Bank of China.
Thanks to resilient infrastructure and property investments, and the lagging effect of credit expansion, there are signs of economic stabilization in China as we enter the third quarter of 2013: manufacturing purchasing managers’ indices have beaten market expectation and returned to the expansionary zone, helped by rising new orders and production activities; both fixed asset investment and retail sales have maintained stable growth; interbank rates have normalized after the People’s Bank of China resumed liquidity injection through its open market operations.
On economic policy, it becomes increasingly clear that the Chinese government is determined to strike a balance between supporting economic growth above a certain level and, at the same time, promoting structural reforms in selected areas. With this minimum growth target in place, there is a so-called “reverse transmission of pressure” on the government to introduce “targeted easing measures” when the risk of economic deceleration arises. As the economy has shown some sequential improvements in recent months, we envisage government leaders putting more emphasis on reform measures to address structural issues, such as local government fiscal constraints and social inequality.
In the final quarter of 2013, all eyes will be on the Chinese government’s master reform plan. With the approach of the Third Plenary Session of the 18th Chinese Communist Party Central Committee (CCPCC) Meeting, we are seeing more government officials’ comments and media reports on new reform initiatives. Potential key reform areas include public finance and taxation, capital market liberalization, urbanization, transfer of rural land rights and social welfare. The CCPCC meeting was recently confirmed to convene in November and the top leaders are expected to unveil their reform blueprint by then.
From a valuation perspective, at current levels Chinese equity markets, including both onshore A-shares and offshore H-shares, offer attractive opportunities for long-term investors. Not only is slower growth largely reflected in prices, but the stabilization and potential transformation of the Chinese economy will also gradually lift investor confidence in the market and lower its required risk premium. That said, we also expect market volatility to stay in the near term as investor sentiment swings. Since the beginning of this year, we have been seeing a divergence of performance between cyclical stocks and non-cyclical growth stocks. While cyclical sectors like basic materials, coal and capital goods continue to suffer from earnings downgrades and de-ratings, growth stocks that are less affected by cyclical growth deceleration, such as healthcare, TMT and utilities, manage to deliver a stellar performance.
As for potential systemic risks of the Chinese market, we consider the negative impact of a deleveraging process and anti-corruption investigations the two major areas to closely monitor. While the former will constrain investment activities by both municipal governments and corporates, the latter will certainly expose some hidden corporate governance issues.
ASEAN & India
The last couple of months saw extreme volatilities in some of the currencies in the ASEAN (Association of Southeast Nations) countries and India as a result of the deteriorating external balances of these countries and concerns on tapering by the Federal Reserve. Countries like Indonesia and India, that have both fiscal deficits and current account deficits, have been especially adversely affected. While we may see a rebound in oversold risk assets, it may be too early to argue these markets have hit the bottom.
We do not believe the South East Asian markets will face a currency meltdown, like the one we saw during the Asian crisis in 1997-98. To a large extent, banks in the region have strengthened and, to date, we do not see signs of bank funding stress. Foreign debt is within reasonable levels. In addition, exchange rates are more flexible now than before.
We believe the Indonesian government is taking the right action by raising interest rates to defend the currency. In fact, Bank Indonesia has raised its main policy rate from 5.75 per cent at the end of June to the current 7.25 per cent. The yield on the 10-year government bond has jumped to well over 8 per cent from a record low of 5.2 per cent at the start of the year. The current account deficit hit 4.4 per cent of GDP in the second quarter, up from 2.6 per cent in the first quarter. Bank Indonesia believes the current account deficit should narrow to 3.4 per cent of GDP in the third quarter. Inflation touched a four year high of 8.8 per cent in August after the government decided to cut costly fuel subsidies in June. We believe interest rates have not peaked yet and there is still pressure to see rates go higher before negative real rates turn positive. Consequently, estimates for economic growth are probably still too high and need to come down to lower levels. Corporate earnings growth momentum will be negative and the equity market valuation still does not look attractive.
India, the worst hit emerging market, has much to do to turnaround the situation. The Indian rupee is down more than 20 per cent against the US dollar this year, making it one of the worst performing currencies in the world. Not surprisingly, India’s foreign exchange reserves have dropped by nearly USD 14 billion since the end of March, equivalent to more than 5 per cent of its reserves. The current account deficit has hit almost 5 per cent of GDP, the largest in a decade. The government has responded by restricting imports, which has reduced the average monthly trade deficit in goods by almost a third since June. The Reserve Bank of India has not done much good to the market by first tightening liquidity, before later changing course and loosening it. This created uncertainty in the foreign exchange market and saw the Indian rupee fall more than 3 per cent in one day, the biggest one-day drop in nearly 20 years. The inverse yield curve suggests that the Indian economy will weaken further. Household consumption is still weak while investment has not recovered. GDP growth saw a 10-year low of 5 per cent in the year ending in March, and the consensus number for the coming year is still on the high side. Meanwhile, consumer prices are rising at annual rate of 9 per cent. The country desperately needs structural reform, but there seems little chance of this. We may have to wait until the next election which will take place next year. The government has come up with some measures recently to curtail the trade deficit, such as raising tariffs on gold. The Reserve Bank of India has also imposed capital controls on residents to prevent capital flight. These measures may help the situation, but they are not enough to fix the economy structurally.
The unintended consequence of quantitative easing in the developing world has been morally hazardous. The availability of external capital has permitted rising budget deficits and made it easier for politicians to put off much needed structural reforms. There is a risk that, as a result of the reversal of the fund flows, we will see falling asset prices, rising interest rates and the weakening of the currencies causing inflation to accelerate. Any slowdown in tapering by the Federal Reserve will only give temporary relief to the Asian emerging countries to buy time for implementing much needed structural reforms. In terms of strategy, we continue to focus on North Asia relative to South East Asia and India.