Devil or angel?

Shell-shocked and confused equity investors are desperately looking for a shelter for the cash they were able to grab as they scrambled out of the turmoil of the US and European markets. Treasuries would seem the most obvious safe haven, Asia’s equity markets perhaps less so. But for some these are desperate times. And with their home markets slumping to levels they have never seen before many say that they are considering all the alternatives.

The more confident fund managers and equity strategists willing to put their heads above the parapet claim that they are definitely Asia focused. They point out that its markets have outperformed the rest of the world. Year to date, Asia Pacific ex-Japan is still up around 4%, although down 10% since May 17.

That’s in sharp contrast to the way in which the steady decline over the past 18 months in the European and US equity markets turned into a tailspin. From May 17 to the end of July the S&P500, for example, slumped 24% as investors clambered out of the equity markets. And after six weeks of remorseless selling nobody appears willing to step forward and predict when the carnage will end. The only certainty nowadays is that any remaining willingness left in these markets to pursue audacious strategies has been extinguished.

The argument goes, for now anyway, that this is proof that the days when America coughed and Asia ended up in hospital with pneumonia are past. So, say these equity strategists and fund managers, Asia is a safe refuge for investors cowering in their bunkers. Or as one managing director at a fund management business in Singapore simply puts it: “Although we like to dress the process up as being a lot more scientific than it is, guessing is actually what our industry is all about. And we feel that Asia, at the moment, looks relatively OK.”

It might not be the most solid recommendation but fund managers and equity strategists in London concur in it. Michael Hughes, chief investment officer at Baring Asset Management, believes that “there is something very special about Asia”. Jennifer Moran, vice president, global equity research, at Deutsche Bank, gives a glowing testimonial: “I am getting the best pulse I have had from Asia since the crisis,” she says. “The clients are all so globally aware and all of a sudden they are back. It’s exciting. And it’s real.”

The opinion echoes around the City. Ewan Cameron Watt, managing director and head of investment strategy and research at Merrill Lynch Investment Managers, says: “To the foreign investor, Asia does appear to be growing at a higher rate than the rest of the world. It’s had the financial crisis, the accounting and corporate scandals, the current account deficits and the market meltdown. Its profitability is now improving, it is under-owned globally, and in absolute and relative terms its valuations are not so extreme.” Add all these factors up and it’s the opposite to the situation that prevails in the US.

A broker based in Hong Kong with a Dutch investment bank is however cynical about comments made by bankers who are based outside the region. She points out that she and her colleagues in Asia bombarded London in May and June in an attempt to sell the Asian story. “We had to go there because foreign investors have been net sellers of Asian stocks since March,” she says. “If they love Asia so much then explain that to me.”

Only one chief investment officer comes close to suggesting why the money has not been so forthcoming this year and allocated to Asia. He nearly chokes on his tea when asked if he thinks that Asian equities are a good place to put money right now. “Officially we see it as a place where there is a lot of business to be done and it has recovered dramatically from the crisis and is a shining example to the rest of us,” he says. “Unofficially, though, we still view it as a basket case.”

This is a particularly harsh statement because anecdotal evidence suggests that the interest is indeed there. Even so, despite global fund managers saying they are attracted by the cheapness of the stock, the benefits of having a globally diversified portfolio, improving returns on equity and increasing domestic demand, few are taking the plunge and putting their money where their mouths are.

As Hugh Young, managing director at Aberdeen Asset Management, says: “We haven’t seen the US investor coming to these markets yet. We are seeing more interest, but it’s not the big thing that everyone is suggesting.”

A dwindling flow

Young’s view is an understatement. In fact foreign investment inflows to the region are drying up and have even turned negative in several countries. According to Ajay Kapur, managing director and regional head of strategy research and equity research at Salomon Smith Barney in Hong Kong, US investors have withdrawn more money from Asian equities than they have from European ones, $1.2 billion compared with $774 million. If Japanese equities are included, net selling by US investors of Asian stock rises to $2.06 billion

Countries hit by the withdrawal include Korea, which receives much praise for the progress made with economic reforms and improvements in corporate governance and transparency. In 2001 it secured huge inflows of capital – $2.1 billion in the second half alone.

By February of this year, though, foreign capital began to leak out. Between February and July the net outflow was $2.9 billion as foreign investors began selling out of their supposed darling market. It is totally contrary to the words of one fund manager, who says: “Korea is where everyone is focused. It is the story.”

Indonesia is also suffering. It made headlines last year and at the beginning of this year because its stock market posted gains of over 40%, making it one of the world’s best performers. Foreign investors piled in with $299 million in the second half of last year. Now it’s trickling back out, with a net outflow of $6 million in June. The trend is set to continue.

The same story is repeated in Thailand, Taiwan and India, which have all experienced large net outflows over the past few months.

Breaking the figures down further, US Treasury statistics indicate that between January and April 2002 US investors were net sellers of Asian stock, dumping $1.2 billion-worth. Hong Kong and Korea suffered the most. As Kapur, who has just returned to Hong Kong from a whistle-stop tour of fund managers around Europe, says: “Chief investment officers are very positive still on Asia. But what I want to know is, if Asia is so attractive to them, then where is the money?”

But perhaps Asia is relatively fortunate. The flight of foreign funds could be so much worse. With political and economic turmoil in South America, dedicated emerging-market investors are not able to cash out of Asia and swap their funds into Latin equities. And they could be prevented from doing so for a while. Argentina’s economy contracted 15% over the past year and successful economic reforms are some way off. A US recovery that will help drag Mexico up is not guaranteed for the short term. And a market-friendly outcome in Brazil’s presidential elections is by no means a certainty.

Although Asia isn’t being viewed by international investors as the safe haven some are suggesting it could be, there can be no denying the region’s improving macroeconomic story. Compared with five years ago the region’s currencies are now undervalued or fairly valued. Since 1997, the average real effective exchange rate is now down 17%.

Most countries in the region are now able to boast of current account surpluses as high as 4% of GDP. In sharp contrast to corporates in the developed markets, Asia’s companies have successfully deleveraged. The oligopoly power of the region’s corporates has increased as overcapacity has been sucked out of the market with the collapse of smaller competitors in overcrowded markets. All this has meant a substantial improvement in earnings for some companies.

Robust growth prospects

Korean company Samsung Electronics, a stock pushed by nearly all equity researchers, is a good example. In the second quarter of this year, its profits increased by W1.92 trillion ($1.62 billion). In addition, economies have robust growth expectations. As a whole, the region could experience an expansion of around 6%. Korea is expected to post growth rates of 6%, India could grow by 6% and Thailand a possible 5%. It’s growth that most developed markets can only dream about.

But there is one factor that Asia bulls promote heavily as one of the main reasons why investors should be turning their attention to the region – the valuation of stock. They trade at 11 times next year’s expected earnings. By contrast, the S&P500 stock index trades at just under 16. As

SSB’s Kapur puts it: “Asia is so much cheaper than the US, even though the 12-13% projected 2002 return on equity is roughly the same. It’s like two cars, one Asian, one American, same model, same year, but one is 40% cheaper.”

However as some market observers point out, stocks are cheap for a reason. Possible accounting scandals, for example, are, according to some equity researchers, already priced in. “Expectations of levels of transparency and corporate governance have always been lower for Asia and that’s incorporated into the valuations,” says Merrill Lynch’s Asia Pacific equity strategist, Spencer White. But because foreign investors are net sellers and not net buyers, it could mean that stocks might still not be cheap enough. Stewart Paterson, chief regional strategist for non-Japan Asia at CSFB, says: “Structurally the region is very strong and valuations on the surface look cheap. But once you start stripping things away, the valuations become reasonable rather than compelling.”

This will be depressing news for those in Asia who rubbed their hands with glee when the US’s accounting and corporate scandals burst to the surface. They believed that this would be a bonus for the region’s markets. They thought that investors would divert funds from the US and her slightly less ugly European sister and put them into Asia.

But as Paterson says: “It is difficult to construct an argument that just because US investors don’t want to hold US equities because of the scandals they are going to come here. For many it would be like jumping from the frying pan straight into the fire. And anyone who suggests that Asia will benefit from the US scandals is being totally disingenuous.” Merrill Lynch’s White agrees: “It would be a gross oversimplification to suggest that just because things go bad over there, it will be good over here.”

Many continue to argue otherwise and say that over the past few months, as US corporate bankruptcies and malpractices pile up, there has definitely been a levelling of expectation. And investors have been building in corporate risk premiums that, while common in Asia, are new to western markets. “[In terms of corporate governance] Asia is definitely progressing. Admittedly, though, things are still a long way from perfection,” says Edwina Neal, global equity strategist at Lehman Brothers. “But for the equity investor they are not so concerned about where the trend is now but the direction it is moving in. And there is a sense that Asia has stopped getting worse, and is moving in the right direction.”

The fact that Asia has stopped getting worse is still not a sufficiently persuasive argument with some investors for them to make an about-turn. And they make it clear they still will not be reaching for the chequebook soon in order to buy into too many Asian equities.

A dramatic rise in risk aversion is evident. One London investor says: “Asia is still a basket case. When you look at companies in the region there will definitely be blow-ups there too. And there is always more than one cockroach in the kitchen. The US isn’t the only place with strange accounting. Asia is still very opaque and in many cases it’s still a question of having your books checked by your brother-in-law.” He says that he no longer has the stomach for further accounting upsets and massaged figures.

Asian-based bankers put on a brave face and look to the future when asked if they are disappointed that foreign flows are reversing or not coming as quickly to the region as they would like. SSB’s Kapur says: “Given the fact that Asia’s shares have outperformed the world index and the fundamentals are so strong, more and more people will find it easier to make the argument to come to Asia. If you weren’t overweight Asia then it’s got to have hurt.”

It is important to remember, however, that several of Asia’s large stocks, such as Hutchison Whampoa, China Mobile and Telstra, have performed poorly. It is really only the mid-caps that have performed well. And there is only so much that you can put into stocks of that size. Ian McLennan, UBS Warburg’s managing director and head of Asian equity strategy, flips the issue regarding disappointment. He suggests that the part of the Asian story that should be focused on is that Asian money is staying at home rather than being sent over to be invested in US treasuries.

Other bankers suggest this too and point out that the region’s markets are dominated by local money, saying that 85% of the turnover in equities is domestically driven. They explain that is also why Asia’s equity markets have not taken the hammering that those elsewhere have. As Cameron Watt says: “The thing that keeps these markets juicing along is not us but the domestic investor.”

Others feel, though, that Asia’s equities are still being penalized because of mistakes in the US and the bursting of its asset bubble. But as Kapur explains: “It is very clear that there has been more aggressive selling in Europe and the US, but when there is a shock there is always a stronger bias to stay in your home market.” In other words, persuading investors to keep money in faraway lands in times of trouble is tough. Persuading them to put more money in is even tougher. “Asians know their markets, they naturally live and breathe Asia. Foreign investors don’t. And don’t underestimate the patriotic optimism of the US investor,” says one banker.

There is another cloud on the horizon that could stop funds flowing into the region and might encourage further outflow – the fear that a US recovery is further away than figures would have us believe. A head of research in London says: “People’s concern about the US is that they are getting growth figures just off the scale. And dare I say that I don’t believe them. The extraordinary strength of the economic data would certainly get conspiracy theorists excited given that many companies are consistently coming out with figures that are dreadful.”

The jury is still out on whether the US will enter a double dip but there is a real fear that the appetite of the US consumer will slump as much as the country’s stock market. A curtailment of spending is a real possibility if US consumers wake up to the realization that their financial planning is under threat unless there is a rebound in the markets.

If this engine is turned off, Asia will get sucked in to the resulting problems since the region’s exports will be affected. Economies, companies and markets will be pulled down. The notion that Asia’s markets have decoupled from the US market would look fragile. “If these markets continue to drift down consumer spending will be affected,” says Gary Jenkins, global head of investment grade credit research at Barclays Capital. “And if this slows, talk of a double dip will become more than just talk. We dismissed the idea at the start of the year, but five out of six recessions in the US were double dip.”

There is the added burden for Asia that if demand for the dollar declines as foreigners start avoiding dollar assets it will affect those exporters that compete directly with China, where the renminbi closely follows the dollar. Southeast Asia is already finding the competition from China tough. The leakage of money out of the region would become a flood.

So what will happen in the short term to Asia? Kapur is still optimistic and doesn’t feel that there will be a further outpouring of foreign money from Asia’s equities. “Stocks are already discounting a double dip because the markets seems to be anticipating one, ignoring other lead indicators,” he says. “The markets should be a lot higher than they are today. And in a few months the valuations will be much stronger and people will look back and say that they should have bought Asian stocks.”

Most bankers seem uncomfortable making solid predictions and sigh deeply when asked to do so. But Merrill Lynch’s White is prepared to give it a go. “I think that you have to set your parameters and expectations very carefully,” he says. “But I believe that Asia will continue to outperform other markets over the next six months because I don’t think growth here will slow that dramatically. Interest rates will remain very low and consumers in select countries such as Malaysia, Thailand and Korea not only have considerable spending firepower but are willing to continue to buy. Thereafter it becomes a lot less clear.”

An equity strategist in London responds very differently: “To be honest, in this current environment I can only advise on what the share price was yesterday and last year’s earnings per share.”

How times have changed. In the good old days everyone was an expert because everyone was making money. Today it’s all down to guesswork. Maybe that’s why international fund managers seem to speak with forked tongues. While paying lip service to the notion that Asian stocks are a great buy, they’re quietly slipping traders the order to sell.