Asia’s Naked Swimmers

Marcuard's Market update by GaveKal Research

Yesterday’s news from emerging Asia was bad: the rupee rout continued with a 2.4% fall to a record low of over 63 against the dollar; Indonesia’s stock market suffered a 6% selloff in US dollar terms while the rupiah fell to its lowest level in four years; and Thailand entered recession with its second straight quarterly GDP decline. The tide is going out and the naked swimmers are washing up on shore in droves.
The tide, of course, is the Fed’s QE policy and its prince is Ben Bernanke, whose hint in May that asset purchases could taper off caused US Treasury yields to nearly double and at a stroke ended the equity and bond bull markets in emerging economies. The big question obviously is how much worse can things get?
The answer is that they will almost certainly get worse in the next few months. But panic is not indicated. Throughout the region—even in India where policy has been comatose or in Thailand where credit growth was overdone—economic fundamentals are decent and national balance sheets are reasonably strong. So what investors should look for is not which economies are going to collapse, but what thresholds must be crossed before the sell-off becomes a buying opportunity.
Despite the brave talk from local brokers, the time to buy has not yet come. The first variable to consider is the level at which US Treasury yields are likely to stop rising. Back in May when the selloff began we suggested the end of QE and a more maturing recovery would justify a 10-year yield of around 3%, which is the current trend rate of nominal GDP growth. We’re quite close to that mark now. US growth is not yet robust enough to push yields sustainably higher, but in big unwindings such as we now see, overshoot is normal. So a plausible scenario is a rise in the 10-year yield to somewhere above 3%, followed by stabilization at a slightly lower level.
At that level, the US 10-year will offer a real yield of 1% to 1.5%. A good rule of thumb is to buy emerging Asian bonds when their real yields offer a spread of around 200bp over treasuries, or in this case 3% to 3.5%. Obviously the rule does not apply to countries facing currency free-fall or material risk of a liquidity crisis.
So far no one in the region offers such a spread. The best placed are Korea, Malaysia and Indonesia, with real 10-year yields in the 2-2.5% range (using the last three months’ average CPI as the deflator). Yields in Thailand, Philippines and Taiwan hover between 1 and 1.5%. India is a special case: using CPI its 10-year note offers zero real yield; against the more widely-used wholesale price index the yield is closer to 4%.
So across the region, yields have further to rise before foreign capital is likely to stream back in and provide support to both bond and equity markets. Once they do rise, economic fundamentals become key. Here India stands out as the big loser: it is caught in stagflation with decelerating growth and stubborn inflation; the high oil price guarantees that its current account deficit (biggest in the region at 5% of GDP) will remain perilously wide; and an ineffectual and exhausted government will continue its zombie-walk toward elections next spring.
No one else in the region is in nearly as bad shape. Indonesia’s current account deficit (4.3% of GDP) is a worry, and like India it faces the uncertainty of elections next year, but its policy has generally been growth oriented and its public and private debt levels are the lowest in emerging Asia. Thailand has a modest positive but deteriorating current account, and is the least competitive and politically least stable of the region’s exporters; it may turn out to be Southeast Asia’s weakest hand.
Taiwan, Korea, Malaysia and the Philippines all run solid current account surpluses. Big current account surpluses deriving mainly from manufactured exports (as in the case of the first three) are generally enough to insulate against other problems, such as the perpetually high private debt levels in Korea and Malaysia. All three of these big exporters will see a quick growth uptick if US demand accelerates next year. The Philippines’ impressive recent resilience probably owes much to the fact that its current account depends less on manufactured exports than on relatively stable remittances from its army of expatriate workers in Asia and the Persian Gulf. But this also means that any resurgence in global manufacturer demand will turn it into a regional under-performer.

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