Under-performance has followed crisis in many Asian emerging markets, but investors may now be able to look forward to some signs of revival, says Kevin Hall
It has not just been the period since the “Asian crisis” that has been disappointing for investors in Asian emerging markets. The region has under-performed against other world markets for a number of years. In the past few months, however, there has been some light at the end of the tunnel as fund managers have finally seen some gains.
Whilst these have been inconsistently spread across the region, those who have been prepared to re-enter the markets have seen their boldness handsomely rewarded. “The major determinants in relative performance between the funds in the Greater China universe [funds investing in China, Hong Kong or Taiwan either on an individual or collective country_basis] over the past 12 months has been the size of cash positions, the speed of reinvesting and the aggressiveness of the investment profile,” says Neil Clare, associate director and Asia Pacific analyst at Standard and Poor's Fund Services.
China funds have had two years of negative performance since the heady days of 1997. Chastened by this, fund managers have been cautious about the markets, and this has led to a number of moves by the government to head off sluggish growth and deflation. Reduced interest rates have led to a liquidity-driven rally, supported by an upturn in cyclical indicators.
Nevertheless sentiment towards medium-term outlook is mixed, partly because of fiscal and corporate management problems, and partly because of worries about social unrest.
Paul Parsons, senior investment manager at Pictet TF Emerging Markets Fund, believes two major issues are key to confidence in China. “Firstly, the question of World Trade Organisation entry needs to be tackled. We believe membership of WTO is vital for the future prospects of China, as it will need foreign investment to successfully reform the state sector. One of the problems is likely to be reluctance to open up telecoms to foreign investors. This will be an issue with the US and other western countries. The other question is whether or not Taiwan will be allowed simultaneous entry.”
Parsons also believes that domestic demand will need to be stimulated to kick-start growth. On this front the recent Communist party congress approved several policies aimed at solving the current deflationary problems, although most of these had already been announced. “We are also seeing exports pick up, but there are worries that this is merely a short-term blip. There is no doubt that there must be reforms to encourage transparency if China is not to risk a Russia-style collapse.”
Political rumours have not helped matters, and the announcement at the congress that President Jiang Zemin was to take control of restructuring from Premier Zhu Rongji was an attempt to lay some worries to rest. Nitin Parekh, Asia analyst at Credit Suisse First Boston in Hong Kong, says, “We expect the process to be more incremental in nature - a contrast to the radical and sometimes volatile programmes of the past. Of the new measures to tackle SOE state-owned_enterprise inertia we find the debt-equity swap programme the most interesting. It could effectively break the triangular debt chain, although there are many technical difficulties outstanding.”
He points out that the successful implementation of the reforms could mean a significant reduction in the current corporate debt burden, which could spark new life in investment. Nevertheless, rising levels of foreign debt and the need to build on any increase in domestic demand by stimulating the export sectors, lead many to believe that a devaluation could be on its way, although analysts have been wrong about that before.
Hong Kong, meanwhile has been rather lacklustre over the past couple of months, as it has been tracking the US market. “Interestingly, Hong Kong has also started to de-couple a little from interest rates, and there has been some better news with the Hong Kong Monetary Authority guaranteeing liquidity to the banking system ahead of Y2K,” says Parekh. Despite the positive news on interest rates the equity market has not reacted.
Parsons, meanwhile sees Taiwan as a market where accumulation can be anticipated. “We are seeing a strict monetary policy being followed, which coupled with good corporate and fiscal governance will maintain enough liquidity to help the economy grow.” He anticipates few surprises, “Except possibly a few political ones emanating from the mainland.”
With its strong fundamentals and vibrant and internationally competitive electronics industry, bolstered by US outsourcing, Taiwan looks set to see a generally improving economic outlook, according to Parekh.
The Asian market remains one that feeds on itself, and so hopes for China markets will be linked to the other smaller markets in the region, and the resurgence in the Japanese economy. That is certainly the opinion of Anna Chapman, Goldman Sachs Asia analyst in Singapore.
“We are overweight in Asia compared with other emerging regions, principally because we are confident that the Japanese recovery will have a positive affect, and also because domestic demand is driving the intra-regional export recovery.” She is also confident that with this growth and with inflation subdued, investors will see earnings growth.
Nevertheless she is keener on the larger northern markets. “Global interest rates have probably bottomed out, and there is definitely a liquidity risk in the smaller markets. Hong Kong, Singapore, Korea and Taiwan should deliver long-term earnings growth, and that will help them continue with fiscal reforms.”
Elsewhere there is encouragement to be found in the positive figures coming out of the Philippines, Thailand, and Indonesia, whose economies are being rebuilt by the stimulation of domestic demand. While all three of these markets have corrected from their 1999 highs, value is starting to emerge. Indonesia has brought forward planned elections, and once a strong government is in place the market should improve, this mood is backed up by the positive view many analysts have of global commodity cyclicals.
Parekh believes the key to Thailand's recovery will be whether the bank recapitalisation can now happen quickly, and at what level the currency will find support. Parsons points out, however that transparency remains a problem in this market, as does the issue of non-performing loans. “Korea has similar problems, but is dealing with them with more transparency, and positive cash flow augurs well for the market.” There remain worries about valuation, liquidity, ITC ??? reform and macro-economic factors in Korea, however, and the banking sector is under-performing.
The Philippines meanwhile continues to see inflation under control, and exports consistently rising due to regional demand and the state of the electronics cycle.
“I am most positive about Malaysia,” says Parsons. “It could well be the focus of next year. There appear to be some cheap companies and the currency is undervalued and we have seen some good trade figures recently. Banking mergers could also drive the index.”
This last is a reference to the government's plans to merge the 21 domestic banks, 25 finance companies and 12 merchant banks into six banking groups. Although the scheme seems to be on schedule, Parekh believes the real test will come when the form of compensation for the selling banks is decided. The worry is that some of these banks are understood to be looking for cash rather than shares or bonds as payment.
Malaysia, however, continues to suffer from corporate governance problems and the links between government and business. Nonetheless the government was able to produce an impressive array of macro-economic figures in September. Manufacturing output, sales and exports all grew by substantial double digits, while inflation was mild.
Worries about Y2K are prevalent in all emerging markets, but a report by Credit Suisse First Boston suggests that the highest-risk markets in Asia are Indonesia, Thailand, Malaysia and the Philippines. Accordingly whilst volumes are sure to tumble across all markets toward the year end, these four could be the worst hit. “Y2K is another reason we favour the larger markets, investors are definitely less at risk there,” says Chapman. “Our research, both top-down infrastructure analysis and company-wide reports, suggest smaller markets could experience problems.”
Elsewhere Singapore and India are two of the success stories of the region. Singapore is offering good value and most analysts are overweight with the majority of sectors from shipping to telecoms performing well. If there is a worry it is that earnings upgrades will not keep pace with interest rate hikes.
India, meanwhile, is dependent on election results, although Parekh is positive. “India remains a firm overweight for us,” he says. “Just about everything is positive for the market at the moment, and a favourable election result will be the trigger for a move above 5,000,” he predicted. “It remains cheap on a top-down basis and a stable government putting the reform package back on track will light the fuse that the market needs lit.”
One of the attractions of the Indian market is its low correlation with world equity markets, including other emerging markets. But worries remain about the new government's determination to tackle the politically difficult, but necessary, structural reforms. Critically as long as the fiscal deficit remains so high, long-term inflation expectations and interest rates will be a constraint on stock valuations. Many large partially-privatised companies are too dependent on government policy, and the markets apply a high discount rating on the earnings of these companies. By and large investors have been stock picking on the Indian market, focusing on growth stocks at the expense of value stocks.
This could be significant for the rest of Asia. Capital scarcity hit India before the rest of the region, and the experience of this market could be repeated elsewhere. Lower barriers to entry and the collapse of pricing power could influence future earnings of capital-intensive manufacturing businesses, while the service sector, under represented in many Asian stock markets, will likely outperform.
The message from Asia is that the longer the recovery continues, the less likely the risk of contagion from other markets. Furthermore, the external risk of liquidity problems is also receding. There is no reason to believe that local liquidity has peaked, and some analysts believe it is unlikely to do so until mid 2000. Indeed, on balance the benefits to Asia of the external environment outweigh the risks, and should continue to see a net inflow of funds.
As mentioned above, risk-takers have benefited most this year, with momentum investing outperforming value investment. Although this could continue next year, the consequences would then be increasing liquidity and valuation risk. The extraordinary performance of small-cap stocks earlier this year also carries dangers, that is to say local investors' return expectations are too inflated.
Generally speaking valuation has not been a catalyst for performance this year, with stocks driven in the main by positive news on growth and earnings, and political reform.
Looking ahead, however, most analysts are reducing their country risk and are being less speculative. Hence the focus on the larger markets where changes in the structure of the underlying economy are most likely to mean that future inflation remains below historical levels. Also comparing the real implied cost of equity now as against before the crisis, the larger markets are looking cheaper than less developed Asia.
Sector strategists suggest that technology-related industries are to be preferred, with both hardware and software featuring. Also, Asian growth gives rise to optimism for domestic and regional cyclicals, such as retail and transport.
Provided Y2K passes without too much wreckage, the region which brought us the "Asian crisis" could well bring us the completion of the Asian recovery in 2000. All eyes will be on Japan, however, as just with other emerging regions, growth is going to be the engine of change.

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