Beware rising Asian stock markets

This is an excerpt from a story that originally appeared in the June edition of AsianInvestor magazine. To learn more about the content in the magazine, please contact Stephen Tang at [email protected] or on +852 2122 5239.

Investors who were bold enough to stay invested in Asian equities from the latter part of last year onwards are reaping the rewards of their bravado. The closely watched MSCI Asia ex-Japan Index was, after all, up 41% in the three-month period ending May 15. The sharp gains in Asian shares have, not surprisingly, triggered a bandwagon effect of investors trying to get in on the action and hoping that they're not too late to cash in later on.

For investors who are looking for a quick buck, Asian equities -- or equities in any market for that matter -- isn't the place to find it. Short-term, Asian stock markets remain volatile and the fact that they have risen by so much in such a short span of time make it even more dangerous ground. If anything, the markets look poised for a correction. It may come later rather than sooner, because the momentum chasers are keeping markets afloat for now, but it will come.

"The global economy has not yet recovered to a healthy state," says Nick Scott, Hong Kong-based CIO for Asian equities at BlackRock. "The rally in March and April is based upon investor relief that things may not be as bad as was predicted, rather than concrete evidence that the worst is over and a recovery is imminent."

For investors who are in this for the long haul -- with one year being the minimum investment horizon -- then the scenario is vastly different. Asian stock markets are generally expected to outperform US and European markets over the long run. The reasons for this optimism is plentiful, including the region's relatively strong domestic consumption, sound fiscal position, ability to counteract external shocks with central bank reserves and fiscal spending, less dependence on exports, stronger financial systems, and  so on and so forth.

Halbis Capital Management, for one, has kept its bullish long-term view of Asian equities intact.

"Overall, we believe the market is showing signs of stabilisation that should allow bottom-up investors such as ourselves to focus once again on picking the right stocks," says Ayaz Ebrahim, Hong Kong-based CEO of Halbis Capital Management. "In the last few months of turbulence, investors have focused more on shifting between defensive and cyclical sectors rather than assessing the fundamentals of the companies themselves."

Still, even for long-term investors, fund managers and analysts are sounding out the alarm bells and warning against chasing the momentum. Waiting for that correction is seen as the best option.

"It is very hard to predict how equities will perform over the next 12 months, particularly following such a strong rally," says Peter Elston, Singapore-based Asian strategist at Aberdeen Asset Management. "We are still in a period of economic turbulence, in which conditions in the short- to medium-term may either improve or deteriorate unpredictably."

Alex Ingham, a London-based emerging markets fund manager at Aviva Investors, believes that a pause in the current rally is "almost certain".

What investors should be mindful at the present are the changes in fundamentals of listed companies, risk tolerance of investors and company-specific outlook. These are the factors that will shape the investment landscape going forward.

"We are beginning to see some discrimination emerging in the markets, different sectors and businesses are starting to demonstrate their ability to either recover more quickly or improve their cost competitiveness," says Colin Ng, the Hong Kong-based regional head for  Asia-Pacific equities at MFC Global Investment Management, the asset management arm of Manulife Financial.

Structural return on equity and earnings growth potential remains higher in Asia than in the world's developed markets, says BlackRock's Scott, who like many fund managers is particularly optimistic on the long-term prospects of China and India.

"China of course is the focal point," says Victor Lee, Hong Kong-based regional investment manager at JP Morgan Asset Management. "We may indeed see China outperforming global markets as the fiscal packages continue to gain traction. It has strong deposit base and fiscal power to keep its economy on track."

Scott says the strengthening links between China and Taiwan may also throw up some interesting opportunities as mainland companies acquire stakes across the Strait. He believes that India's economy has cooled as foreign funding has dried up, but that has created some insulation from the collapse in global demand.

Not everyone's a fan of China, though.

Desmond Tjiang, Hong Kong-based CIO for Asia ex-Japan equities at Fortis Investments, is wary of the rally in Chinese shares and doubts it is sustainable.

"The consensus overweight in China is a risk because that market is overcrowded," says Tjiang, who is bullish instead on Indonesia. He believes that the strong domestic consumption in Indonesia, citing that country's urbanisation, infrastructure, and domestic consumption trends.

Rajiv Jain, managing director for international equities at Vontobel Asset Management in New York, says the notion that Chinese domestic demand is going to rescue the region in fiction.

"Chinese domestic consumption is less than that of the UK," Jain notes. "An increase there isn't going to move the needle."

Worse, it's in China where the greatest overcapacity exists in areas such as steel and cement. China's infrastructure spending program is good at boosting GDP figures by adding capacity, but does nothing to help corporate profitability.

Moreover, Jain is sceptical about the ability of government stimulus programs to ultimately boost corporate earnings.

"We don't trust any government. Why do investors have such confidence in Beijing? Chinese steel companies are being instructed to produce more and not lay off workers, at a time when capacity utilisation rate are at their lowest in 50 years."

Too many investors are mesmerised by the Asian growth story, but Jain calculates that over the long term, Chinese corporate earnings growth rates have been about the same as America's -- but Chinese stocks are priced far more ambitious.

Jain says the past five years were a bubble and have clouded investors' expectations about growth in China and other Asian markets. The argument that Asian corporate balance sheets are strong is fine for bondholders but doesn't equate to earnings growth.