The end of Asian equity market underperformance?
With Asian equities having underperformed their global equivalents by almost 40% since 2011, the past five years have not been much fun for regional investors. Encouragingly, however, just as the panic over a possible China currency crisis and economic implosion reached its apex last summer, Asia’s underperformance seems to have abated. Over the following eight months or so, Asian equities have held their own with a number posting decent YTD gains in US dollar terms. Taiwan, for example, is up 4.7% for the year, the Philippines 3.7%, Korea 5.7%, Singapore 6%, Malaysia 11.6%, Indonesia 12.4%, and Thailand 15%.
Last week, our analysts Joyce and Udith argued that the prevalence of high corporate leverage and industrial overcapacity remained a significant threat to Asian equity markets. But at the same time, one could argue that markets are made at the margin; and on this front, the three key developments of recent months are:
1) The fact that the US dollar is done rising.
While the end of US dollar strength has been a constant theme of Gavekal Research for the past year, we probably should have spilled more ink on the investment consequences of this “squeeze” ending. One of the most immediately obvious consequences is that a US dollar which has stopped rising offers emerging markets everywhere a huge gulp of oxygen. Hence, if the US dollar really is done rising, history suggests that emerging markets’ underperformance will cease. In that respect, the recent moves in the Singapore dollar are very interesting: last week, the Monetary Authority of Singapore surprised the market with unannounced easing and a very dovish stance. This triggered a sharp pullback in the Singapore dollar. But interestingly, the pullback faded quickly and within 48 hours, the Sing dollar was above the level before the announcement.
2) The collapse in bond yields.
The past ten days or so have shown that investors around the world are back to chasing yield. From yields on US sub-investment grade energy debt contracting by more than 9pp, to Argentina pulling in US$50bn of orders for a new 30-year bond issue (has Argentina ever gone 30 years without defaulting on its debt?), to Saudi Arabia raising US$10bn at Libor+120bp, emerging markets’ cost of funding is again heading lower. In Asia, exhibit-A has been Indonesia where the government’s local currency funding costs have fallen from 9% at the start of the year, to 7.5% today. What is particularly interesting about the Indonesian yield compression is how, this year, it has been completely uncorrelated to the greater risk-on/risk-off moves in the broader market (Indonesian yields fell in January and February even as global equities sold off).
While investors fretted about a renminbi devaluation or a Chinese debt crisis, the real estate market was busy bottoming with a pick-up in prices, housing starts, new construction and sales. At the same time, Chinese central bank reserves started to inch higher while bond yields continued to decline. Of course, all these positive trends could once again reverse. Still, as long as they endure, an immediate collapse in China seems highly unlikely. This new reality is shown by the rebound in the price of commodities such as iron-ore, crude oil and silver.
Staying with China, one direct consequence of the past nine months’ foreign investor panic was a brutal sell-off in the Chinese offshore (dim-sum) bond market (red line in the chart). Simply put, no foreign investor wanted to be seen holding any kind of renminbi paper. Meanwhile, in the domestic market, the People’s Bank of China continued to ease monetary policy and inject liquidity, thereby driving domestic yields lower (blue line in chart). In fact, domestic renminbi yields fell so much that a massive gap opened up between the onshore and offshore market. Of course, as markets have now started to normalize, this difference in yield is being squeezed away (even if there is still a good 100bp of juice left in the “long dim-sum” bond trade). And if, as seems likely (given the growing financial deregulation in China), the yields on onshore and offshore bonds go back to converging (as they did for most of the first half of 2015), then this fall in interest rates, and normalisation of funding markets, could well underpin the valuation of Chinese offshore equities (that remain close to record lows).
So, if as I believe, the new macro environment is defined by a roughly stable US dollar, a roughly stable China, and a renewed appetite for yield among investors, then, current valuations and investor positioning imply that the most likely scenario is for Asian equity markets to break the past five years’ underperformance trend.