Asian stocks caught in currency war crossfire

Forget for a moment how badly stocks have done this year. For investors in Asia, stock returns mean little without factoring in the outlook for the region's currencies.

And that outlook isn't so hot. So far in 2016, the dollar has fallen, the yen has climbed and the yuan has marked time. That's produced a mixed bag of results for stocks, pulling down big Northeast Asian markets like China and South Korea alongside Tokyo amid fears a stronger yen will hurt everyone's exports, but pushing up stocks in Southeast Asia like Indonesia as global investors pump funds back into relatively riskier markets. While the broader MSCI AC Asia index has fallen roughly 11%, therefore, the MSCI Southeast Asia index has lost only about 1%.

As Nomura's currency strategist Craig Chan and his colleagues describe in their latest report, which way Asia's currencies move will depend on the direction of just three: The US dollar, the Japanese yen and China's yuan. And where those go will depend on decisions at the US Federal Reserve, the Bank of Japan (BoJ) and the People's Bank of China (PBoC).

Currency moves can be a doubleedged sword for stocks. Experienced investors won't have forgotten how a 9% gain in Japanese equities in 2014 turned into a 5%, US dollar loss thanks to a 12% drop in the yen. That helped fuel the popularity of currency-hedged ETFs. But they're not foolproof: Thanks to the yen's recent spurt, the un-hedged iShares MSCI Japan ETF has outperformed iShares Currency Hedged MSCI Japan by roughly 4.7 percentage points so far this year.

Both Taiwan and Malaysian stocks have dropped 1.9% so far this year. But thanks to a rising Malaysian ringgit and a falling Taiwan dollar, Malaysian stocks have returned 1.4% in US dollar terms, while Taiwan's stocks have lost 4%. Indonesia's 3.7% gain looks good, but its 6.9% gain in US dollars looks even better.

This situation seems unlikely to last. The Fed appears convinced the US economy is strong enough to justify at least some interest rate increases, the BOJ is determined to use negative interest rates to weaken the yen and restore growth, and the PBoC can only hold the yuan up so long against slowing growth and rising capital outflows.

Any sign the Fed will hike will push the dollar up at the expense of Asian currencies, or any sign the BOJ and PBoC might weaken their own currencies would push Asian currencies lower in tandem. Nomura's strategists recommend selling China's yuan, Korean won, Taiwan dollars, Hong Kong dollars, Singapore dollars and Thai baht, but buying Indian rupees and Philippine pesos.

No one can predict which currencies will fall most. But just how vulnerable each Asian market is to these flows depends on a variety of local factors, including how much they rely on exports, foreign debt, foreign investment and trading with China.

Two of the most vulnerable are the region's financial centers, Singapore and Hong Kong. Both are highly exposed to trade and investment flows and have high external corporate debt, which would unwind fast if investors take flight. Hong Kong's dollar is pegged to the greenback, meaning attacks on its currency get expressed in the stock market – the Hang Seng index has dropped 12% so far this year.

Then there's Malaysia, whose ringgit has fallen 13.4% in the past year. Malaysia's vulnerability stems neither from its role as a net oil exporter nor from the unfolding political scandal in Kuala Lumpur, but from relatively high external government borrowing and high foreign investment in local bonds and stocks. With so much portfolio money flowing in and out, the ringgit and can move far, fast.

The same goes for the commodity exporting duo of Australia and New Zealand. Australia's central bank is wise enough to let the Aussie dollar absorb much of the shock from shifting trade and investment, meaning it also has little socked away in reserves to defend it in case of a rapid drop. Ditto New Zealand.

So which Asian markets are least vulnerable to big currency swings?

Thailand has less to fear from a foreign stampede because foreigners leery of its military government have already skedaddled. It's further insulated by a current-account surplus and low government external debt.

Low foreign debt also supports the Philippine peso, together with a steady stream of remittances by workers overseas. Those remittances should withstand slowing global growth even as more workers go home to take advantage of an improving job market.

India's rupee, which took a drubbing in 2013's Taper Tantrum, now looks more resilient thanks to relatively low external debt and India's low exposure to trade with a slowing China.

But it's China's yuan that stands out as Asia's most resilient currency. Repaying foreign debt and capital flight are putting downward pressure on the redback. But China's foreign debt is trifling compared to its neighbors'. And while China's outflows are falling at a record pace, reserves have been falling even faster in Australia, Malaysia and Vietnam.

Make no mistake: The PBoC is still likely to steer the yuan lower. But it's unlikely to aim for as dramatic a decline as the BOJ. And when it finally does, Asia's other currencies are likely to fall even further.

Comments? E-mail us at wayne. arnold@barrons.com