Surreality looms, says RAB Capital
Portfolio managers at RABÆs Pi Asia fund are making good returns this year, but they expect that forthcoming economic data will contain some surreal surprises.
RAB Pi Asia is an equity long/short fund investing across the market capitalisation spectrum in Asia. AsianInvestor spoke to fund managers Caesar Luk and Alain Barbezat, and head of trading Nissim Tse.
What is your performance?
Tse: The fund was up 6.89% in September and we are currently up 3.8% for the year.
What messages are you getting from investors?
Luk: Investors are clearly shocked, for two reasons. First, in their minds, the falls on Asian markets were not supposed to happen as they believed for too long in the decoupling argument. Second, they are shell-shocked that, for the most part, their hedge fund managers were totally unable to protect capital in the downturn.
What is your perception of the markets right now?
Barbezat: Shorter term, the markets have enjoyed another nice flashy post-policy-announcement rally from oversold levels û the sixth bear market rally of the past year. One of these days, it will be a true inflection point for the next bull market but this day hasn't come yet.
The last measures are again just a medicine, not the cure. How the market responds to what we anticipate is going to be a surreal set of adverse economic data in coming months and quarters will be key.
We have expressed many times in the past few months our concerns with regards to earnings growth expectations that are too high for both 2008 and 2009 and these concerns remain. Leading indicators are pointing to a 1973-1975 type of severe recession from which we will not emerge before 2010. Hence, our forecast that the low point will be some time around mid-2009 at the earliest stands.
The housing recession began more than two years ago and is ongoing.
The capex recession began two quarters ago, and it too is ongoing as profits and industry operating rates decline.
But the new story is that the consumer recession has arrived. The last data shows that consumer credit plunged by a record $7.9 billion in August and this supports the view that the consumer sector is now embarking on a process of asset liquidation, debt repayment and higher savings.
How about Asia specifically?
Luk: Talking about Asia, profits in the last couple of years are reflective of the overhang of global liquidity created up to last year. By this time next year the squeeze on profit will be much more acute. Even if commodity prices halve or more from here it will not make a difference as it will be revenues that bring the problem, not costs.
It is difficult to think of a clear winner in this environment but companies cutting costs and labour are ahead of the game. Bottom-up analysis and stock-picking will soon be able to make a difference again. The reason we say this is because market action of late has been driven by indiscriminate liquidation.
What started as a credit crisis in the US a year ago has morphed into a massive and broad-based liquidation of various asset markets. Liquidation episodes tend to undershoot and create good buying opportunities. During these episodes, fear replaces greed and forced liquidation implies that fundamental analysis offers little help in getting markets right, at least in the short term.
So far, the worst of the credit crunch has not hit Asia. Asian banks and borrowers have been especially conservative over the last 10 years, having learned their lessons from 1998. With the exception of Korea, none of the countries caught up in the Asian financial crisis have loan-to-deposit ratios approaching those prevailing in 1997.
So, with unleveraged balance sheets at the household and corporate level most Asian countries are relatively well placed to weather the credit storm. Unfortunately, they are not well placed to weather the downturn in demand that goes with it. As predominantly either manufacturing centres or major raw material suppliers, they are hostage to operational gearing. Investment in plant, machinery and mines requires that high capacity utilisation levels are maintained in order to make good returns.
When demand slows, either capacity utilisation goes down or the selling price of goods goes down. Usually, it's a combination of both. Over the next 18 months Asian corporate profitability will remain under pressure. There is still a strong belief that ChinaÆs growth can support economic activity û and hence earnings û in the region.
Barbezat: We suspect that many companies and industries have operationally geared up for China to maintain double-digit growth and, if that is the case, then there are bound to be significant corporate earnings disappointments from that source alone.
If the ROE today were to fall to the same levels as in the last two downturns, 1990 and 2001, EPS would be down between 30% and 50%. It may not get as bad as in the last two downturns (although everything tells us at this point that it could be worse), but positive EPS growth is equivalent to a multi standard deviation event.
Over the course of the past few years EBIT margins have fallen off a cliff thanks to the terms of trade, while asset turn has shot through the roof on the back of very strong export growth to both the US and Europe. All well and good: margin squeeze offset by volume growth. Make less money on each widget, but sell more of them. This is what has been driving ROE and hence EPS. That trade has come to an end. Everywhere we look, the slowdown signs are ominous.
How you are positioning the fund currently?
Luk: For now we continue to navigate carefully, keeping our exposures low and focusing on very selective investments. We have, however, redoubled our efforts to identify the clear winners once markets are allowed to clear, one way or another. Interestingly, the biggest earnings cuts come from Japan.
One might suggest that these analysts are more familiar with bear market conditions and are therefore more comfortable taking a more considered, measured view of how bad things might get. They are not as expectant of a fast turnaround to market and economic direction. This pragmatism and experience in downgrading could serve Japan well in the near future as it could adjust to more reasonable assumptions quickly while others are still working on the lengthy process of slowly paring expectations.
Barbezat: China is another interesting candidate in the mid-term as the market is now trading at a discount to the region and the possibility of a large-scale fiscal stimulus could positively influence both 2009 earnings and valuation. Taiwan is fast becoming interesting from a stock pickerÆs point of view following a steep decline since May 2008. Korea is worrying because of its leveraged banking system and high cyclicality. Elsewhere in Southeast Asia, political problems or continuously poor corporate governance outstrip low valuations at this point.
What problems are the shorting restrictions causing you?
Tse: Only a limited number of countries have imposed shorting restrictions in Asia, so it is not really causing any insurmountable problems. For those who have, we have taken the decision to close our positions unilaterally, both long and shorts, as the flip side of banning shorts creates additional pressure on long positions as any short covering leaves hedge funds exposed to longs only. Clearly an unacceptable state of affairs for any hedge fund.
What is your performance?
Tse: The fund was up 6.89% in September and we are currently up 3.8% for the year.
What messages are you getting from investors?
Luk: Investors are clearly shocked, for two reasons. First, in their minds, the falls on Asian markets were not supposed to happen as they believed for too long in the decoupling argument. Second, they are shell-shocked that, for the most part, their hedge fund managers were totally unable to protect capital in the downturn.
What is your perception of the markets right now?
Barbezat: Shorter term, the markets have enjoyed another nice flashy post-policy-announcement rally from oversold levels û the sixth bear market rally of the past year. One of these days, it will be a true inflection point for the next bull market but this day hasn't come yet.
The last measures are again just a medicine, not the cure. How the market responds to what we anticipate is going to be a surreal set of adverse economic data in coming months and quarters will be key.
We have expressed many times in the past few months our concerns with regards to earnings growth expectations that are too high for both 2008 and 2009 and these concerns remain. Leading indicators are pointing to a 1973-1975 type of severe recession from which we will not emerge before 2010. Hence, our forecast that the low point will be some time around mid-2009 at the earliest stands.
The housing recession began more than two years ago and is ongoing.
The capex recession began two quarters ago, and it too is ongoing as profits and industry operating rates decline.
But the new story is that the consumer recession has arrived. The last data shows that consumer credit plunged by a record $7.9 billion in August and this supports the view that the consumer sector is now embarking on a process of asset liquidation, debt repayment and higher savings.
How about Asia specifically?
Luk: Talking about Asia, profits in the last couple of years are reflective of the overhang of global liquidity created up to last year. By this time next year the squeeze on profit will be much more acute. Even if commodity prices halve or more from here it will not make a difference as it will be revenues that bring the problem, not costs.
It is difficult to think of a clear winner in this environment but companies cutting costs and labour are ahead of the game. Bottom-up analysis and stock-picking will soon be able to make a difference again. The reason we say this is because market action of late has been driven by indiscriminate liquidation.
What started as a credit crisis in the US a year ago has morphed into a massive and broad-based liquidation of various asset markets. Liquidation episodes tend to undershoot and create good buying opportunities. During these episodes, fear replaces greed and forced liquidation implies that fundamental analysis offers little help in getting markets right, at least in the short term.
So far, the worst of the credit crunch has not hit Asia. Asian banks and borrowers have been especially conservative over the last 10 years, having learned their lessons from 1998. With the exception of Korea, none of the countries caught up in the Asian financial crisis have loan-to-deposit ratios approaching those prevailing in 1997.
So, with unleveraged balance sheets at the household and corporate level most Asian countries are relatively well placed to weather the credit storm. Unfortunately, they are not well placed to weather the downturn in demand that goes with it. As predominantly either manufacturing centres or major raw material suppliers, they are hostage to operational gearing. Investment in plant, machinery and mines requires that high capacity utilisation levels are maintained in order to make good returns.
When demand slows, either capacity utilisation goes down or the selling price of goods goes down. Usually, it's a combination of both. Over the next 18 months Asian corporate profitability will remain under pressure. There is still a strong belief that ChinaÆs growth can support economic activity û and hence earnings û in the region.
Barbezat: We suspect that many companies and industries have operationally geared up for China to maintain double-digit growth and, if that is the case, then there are bound to be significant corporate earnings disappointments from that source alone.
If the ROE today were to fall to the same levels as in the last two downturns, 1990 and 2001, EPS would be down between 30% and 50%. It may not get as bad as in the last two downturns (although everything tells us at this point that it could be worse), but positive EPS growth is equivalent to a multi standard deviation event.
Over the course of the past few years EBIT margins have fallen off a cliff thanks to the terms of trade, while asset turn has shot through the roof on the back of very strong export growth to both the US and Europe. All well and good: margin squeeze offset by volume growth. Make less money on each widget, but sell more of them. This is what has been driving ROE and hence EPS. That trade has come to an end. Everywhere we look, the slowdown signs are ominous.
How you are positioning the fund currently?
Luk: For now we continue to navigate carefully, keeping our exposures low and focusing on very selective investments. We have, however, redoubled our efforts to identify the clear winners once markets are allowed to clear, one way or another. Interestingly, the biggest earnings cuts come from Japan.
One might suggest that these analysts are more familiar with bear market conditions and are therefore more comfortable taking a more considered, measured view of how bad things might get. They are not as expectant of a fast turnaround to market and economic direction. This pragmatism and experience in downgrading could serve Japan well in the near future as it could adjust to more reasonable assumptions quickly while others are still working on the lengthy process of slowly paring expectations.
Barbezat: China is another interesting candidate in the mid-term as the market is now trading at a discount to the region and the possibility of a large-scale fiscal stimulus could positively influence both 2009 earnings and valuation. Taiwan is fast becoming interesting from a stock pickerÆs point of view following a steep decline since May 2008. Korea is worrying because of its leveraged banking system and high cyclicality. Elsewhere in Southeast Asia, political problems or continuously poor corporate governance outstrip low valuations at this point.
What problems are the shorting restrictions causing you?
Tse: Only a limited number of countries have imposed shorting restrictions in Asia, so it is not really causing any insurmountable problems. For those who have, we have taken the decision to close our positions unilaterally, both long and shorts, as the flip side of banning shorts creates additional pressure on long positions as any short covering leaves hedge funds exposed to longs only. Clearly an unacceptable state of affairs for any hedge fund.
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