Decade of the Asian Bull
A plunge in the Fed’s overnight borrowing rate could provide a steroid shot for Asia’s stock market valuation, making Asia the easy money superstar of 2008, forecasts Matein Khalid

With the exception of Shanghai A shares in China, Asian stock indices were victims of the credit crunch and subsequent trauma on Wall Street. The negative correlation of Asia to risk aversion was anchored by the unwinding of the Japanese yen carry trade, whose greatest beneficiaries were the stock markets and currencies of Southeast Asia, India, Australia, New Zealand, Taiwan and South Korea. Asian stock markets were also hit by the forced selling of hedge funds, particularly FDI driven bourses such as South Korea, Taiwan and India. While LBO debt in Asia is miniscule, a number of Asian banks have invested in subprime and CDO securities, led by the Bank of China’s US$9.8 billion exposure and DBS’s US$2 billion exposure.

Of course, Asian stock markets are also vulnerable to recession risk in the US, which can prove catastrophic for the export growth led, open economies of the Pacific Basin. However, while the credit crunch is unquestionably a deflation shock to the US economy and recession risk is not at all marginal, the Federal Reserve will do its best to pre-empt any softness in the US consumer and payroll data. This means the Fed will be forced to revert to easy money policies to bail out Wall Street’s merchants of leverage and speculative excess; akin to its policy response during the New York banking crisis of 1991, LTCM/Russia in 1998 and the collapse of the tech bubble in 2000.

Yet the plunge in the Fed’s overnight borrowing rate could provide a steroid shot for Asia’s stock market valuation. In essence, just as Nasdaq techs became the world’s favourite asset class after the Fed’s easy money gift in 1998, Asia could become the easy money superstar of 2008. Valuation multiples in Asia are certain to rise despite epic events such as the collapse of the Silicon Valley tech bubble, 9/11, SARS, the Iraq War and a tripling in crude oil prices. The fact also remains that the Asian Pacific stock indices have outperformed the MSCI All Country World Index. Asian Pacific markets are no longer dirt cheap (with the exception of Thailand) but they are not particularly expensive either at 14 times forward earnings. Moreover, the domestic demand momentum in the Pacific Rim coupled with an entirely novel change in the consumer spending and borrowing paradigms suggests that 14 times 2008 earnings is a modest price to pay for exposure to some of the world’s fastest growing economies.
 

Cultural positives
In retrospect, the Asian FX and stock market meltdown of 1998 marked one of history’s legendary bottom fishing opportunities. The Asian crisis also spawned a culture of risk aversion that ensured that companies de-leveraged their balance sheets, bankers became prudent in extending credit, and consumers boosted savings rates. In fact, the psychology of risk aversion in Asia was a diametric opposite to the credit bubble and leverage mania that swept Wall Street since the late 1990s. It is, therefore, no coincidence that foreign investors have driven the rally in Asian equities. This trend will probably rise as sovereign wealth funds in the GCC, Russia and China all seek to access the world’s most explosive secular economic growth story. Of course, it is entirely possible that foreign ownership will trigger excessive volatility in Asian shares, as we witnessed in August. Yet, foreign buyers will also lead to an incremental rise in Asia’s valuation metrics relative to the SP 500, Europe and the Emerging markets as it attracts domestic liquidity still invested in low yielding bank accounts. This is the reason I expect a cut in the Fed Funds rate and a fall in US Treasury bond yields to be a positive signal for Asian equities.

Mutual funds, commercial banks, pension funds and insurance companies are still nowhere near excessively invested in their home markets and their holdings in fixed income and money markets instruments are far too excessive. For instance, Thai mutual funds have US$3 invested in the bond market for every US$1 invested in equities.

Most Asian national provident fund and pension fund schemes have only 20 per cent investment in their local stock market. Both South Korea and Taiwan have announced strategic allocations to local equities in the years ahead.

Bank indicators
Asian banking systems exhibit some of the lowest loan to deposit ratios in the emerging markets. Moreover, even though the Fed and the ECB have engineered sharply higher interest rates since the summer of 2004, Asian three-month money markets rates are among the lowest in the world, less than 1 per cent in Thailand, and less than 3 per cent in Singapore, Taiwan, South Korea and the Philippines. This excessively low risk free bank deposit rates are also a compelling argument to accumulate Asian equities. Moreover, as Asian property prices rise and home mortgage finance becomes ubiquitous, it is entirely possible that a greater proportion of Asian savings will be reallocated from bank deposits or money markets into equities.

China’s stock market bubble, paradoxically, camouflages the prudent risk aversion of non-PRC Asian investors. Of course, it is important to note that the Middle Kingdom, with its closed capital account, was never assailed by the 1997-1998 Asian financial meltdown. China’s negative real interest rates and lack of pension scheme also encourage speculative behaviour. Yet, even the mania in Shanghai A shares has a potential spillover impact on other Asian stock markets, not just on Hong Kong red chips and H shares. This is because the Qualified Domestic Institutional Investor (QDII) scheme will lead to Chinese money flows into the Asian stock markets. The corollary also holds true to a certain extent. A collapse in the Chinese A share market will have ominous implications for the Hong Kong’s Hang Seng index.

The bullish case for Asian equities must also incorporate China’s new willingness to use its trillion dollar central bank reserves to invest in higher risk securities offshore. China’s US$3 billion pre-IPO stake in Blackstone and China Development Bank’s agreement to finance Barclay’s bid for ABN Amro demonstrates Beijing’s willingness to emulate Singapore’s Temasek model. After all, Asian central banks reserves (not including the Bank of Japan) at US$3.5 trillion are far in excess of any war chest needed to defend undervalued, not overvalued currencies. As Asian governments reduce their colossal holdings in US Treasury bonds, the potential for a secular rating in Asian equities only rises. Asia’s stock markets are still correlated to Wall Street for now. But Asian valuation metrics are headed significantly higher in the decade ahead. This is the decade of the Asia Bull!

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