Marcuard's Market update by GaveKal Dragonomics
Some 18 months after US stocks regained the ground lost in the 2008-09 crisis, emerging Asia has finally made a new high. Last Thursday, the MSCI emerging Asia US dollar total return index closed above its 2007 peak for the first time, having risen 10% year-to-date. That makes emerging Asia the best performing major regional market in the world so far in 2014. If you invest equally in the countries in the index’s universe, your gains are even better: up 15%, with little volatility. After such a stellar performance, it is time to step back and ask whether the rally is sustainable.
Faced with such a question we always return to our contention that a bull market rests on three pillars: valuations, growth and monetary conditions. So where does emerging Asia sit?
After the recent rally, Asian valuations no longer scream “Buy!” but neither are they excessively stretched. The headline index valuation is still below its long term mean, but on an equally-weighted basis, markets look fairly valued. The low headline number reflects investors’ skepticism towards Chinese banks, whose potential problems are no secret. If anything, the valuation picture in emerging Asia is best characterised by its widening dispersion. Among the industry groups classified by GICS, those with valuations in the lowest tenth percentile are cheap by historical standards, while the top tenth percentile are approaching new highs.
The second pillar—growth—poses little threat to emerging Asia. As we detailed in a previous article “The Case For (Some) Emerging Markets”, although the ‘triple merit’ boom of the last decade will not be repeated, the new normal for emerging markets will still be nominal US dollar growth rates of 7-8%, and potentially even higher in Asia. Indeed, Asia’s earnings per share growth beats that of other emerging regions over the past year and compares well with US EPS growth, despite the impact of tapering fears.
Even so, investors remain cautious about acknowledging the earnings prospects of Asian companies. Their concerns rest mainly on the suspicion that regional earnings are a mirage created by illusory Chinese bank profits. However in reality, away from the financial sector, EPS have grown decently in China over recent years.
Investors also fear that the earnings of non-Chinese companies will be held down by disinflationary pressures emanating from China. This is a valid concern. Chinese producer prices have been in decline for more than two years, reflecting competitive pricing by Chinese producers as capacity utilisation remains low, and China’s sluggish demand growth. Against this backdrop, anyone who competes with or sells to China has limited bargaining power. The good news is that our preferred leading indicator of China’s PPI, an equally-weighted index of oil, metal and food prices, shows that prices should soon stop falling and may pick up. In that case, the long-awaited bounce in Asian exports promised by developed world business surveys should start to materialise. The message is supported by Asian PMIs which in aggregate point to a brighter outlook for the coming months.
The greatest uncertainty is the monetary pillar. On one hand, the European Central Bank and the Bank of Japan are biased towards easing. On the other, the Fed is moving towards tightening, while prospects for domestically-driven liquidity expansion are limited considering emerging Asia’s corporate debt load.
With valuations in the sectors that benefited most from low global interest rates looking stretched, now may be an opportune time to shift out of liquidity plays like the Philippines, Malaysia, utilities and high yield stocks, and towards growth plays like Korean and Taiwanese exporters and other cyclicals.
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