2Q Reality Check...

1Q12 was a quarter that defied expectations. Despite simmering tensions in Europe over its sovereign debt crisis, financial markets built on the momentum that had begun in November last year to propel risk assets higher.

At the start of the year, we forecast that 2012 would be more favourable to risk assets and pointed out that valuations were attractive and with central banks keeping monetary stance accommodative, all that was needed was for risk premium to recede. We got that bit right except for the timing. We were initially expecting better times only during the latter part of the year. But global equities roared back with an 11% gain in USD terms during the first quarter capping one of its best starts to the year in a decade.

Notably, for the period, most major asset classes – equities, credits and commodities – appreciated. The exceptions are government bonds and the USD – the typical bastions of global safe haven. Clearly, this is an indication of a better risk taking environment. Three major themes have dominated global markets during this period which resulted in lowering risk premiums that we had expected.

First and foremost, the critical point in the European sovereign debt crisis seems to be behind us. The risk of a break-up of the Euro-zone and an implosion of its banking system have receded dramatically after the actions of the European Central Bank (ECB) to pump money into the banking system as well as the successful and orderly restructuring of the Greek government debt. Additionally, the Euro-zone governments have also agreed on raising their financial firewall to 700 billion Euros by combining the temporary European Financial Stability Facility (EFSF) with the new European Stability Mechanism (ESM).

The second big factor was action by the major central banks to continue to flood the financial system with liquidity. The ECB has effectively staged a back-door quantitative easing (QE) by lending over 1 trillion Euros to European financial institutions with two tranches of three-year funding operations, or LTROs in December and February. Meanwhile, in January, the US Federal Reserve took a historic step by setting an inflation target of 2% and at the same time signalled its intent to keep interest rates near zero until late 2014 and did not rule out a third round of QE. And across the Pacific Ocean, the Bank of Japan (BOJ) unexpectedly added 10 trillion yen to its quantitative easing while taking a leaf from the Fed, also announced an inflation target but at 1%. These actions by the G3 central banks effectively set a dovish tone to global monetary policy in the foreseeable future.

Third, but not least, is the stronger than expected economic recovery in the US even though the current pace still pales in comparison with most other recoveries, including the one following the Great Depression. Both the manufacturing and services sector indicators have continued to signal expansion while the housing market has bottomed. More importantly, the unemployment rate has come off from above 9% since October with more than 1 million jobs created since then. Consequently, consumer confidence has recovered and consumer spending is on the rise. With this trajectory, the US should be on track to beat IMF’s projection of a 1.8% GDP growth for 2012.

Over the past few months, we have added incrementally to equities as our investment framework, which looks at critical drivers such as liquidity, earnings, valuations, interest rates and technicals, has turned constructive in January. In particular, the single most important factor in our decision has been the receding tail risk of an implosion in the Eurozone. This has allowed for the equity risk premium to fall and for investors to once again focus on fundamentals. In addition, the leading central banks have committed themselves to inflation targeting which given the anaemic state of the global economic recovery means they will continue to hold rates at the current super low levels and to stand ready to provide further liquidity if and when needed.

So far, so good. Equities have recovered 20% from their October lows. The S&P 500 index is back at levels last seen before the Lehman crisis. Can the rally continue?

From a valuation standpoint, there is still significant room for further re-rating. Over the past decade, equity returns have failed to keep pace with corporate earnings leading to falling multiples during the period. The flip side of this de-rating is the rise in the equity risk premium. The excesses in the corporate world, the banking systems and the deterioration in the fiscal state of governments in the West have led to greater market volatility which in turn led to investors demanding a higher risk premium for holding equities over bonds.

 

A critical factor to this equity re-rating and a fall in the equity risk premium is the trajectory of the global economic recovery, especially in the US and China. A sustainable recovery that is characterised by virtuous circles where rising incomes and demand reinforce one another will give markets the impetus to re-rate. And although events in Europe will still matter, we believe that for the moment policymakers there have effectively kicked the can down the road.

In late March, Fed Chairman Ben Bernanke mused about the state of the US labour market and pointed out that improvements in the US labour market have not exactly been matched by growth in final demand. Friday’s disappointing US employment report where the economy added just 102,000 jobs compared with an expectation of over 200,000 seemed to have vindicated his concerns. Investors are starting to ask if the current momentum will give way to a sluggish second half repeating the pattern in 2010 and 2011.

That said the labour situation, although critical to a follow-through in final demand, is not the only driver. Other factors such as global manufacturing activity, new orders and bank lending have shown signs of improvement as well. Moreover, it is far too early to surmise that the US labour market has started to contract with just one dismal job report. 

In our view, the likely outcome is continued job gains in the months ahead but it will be somewhat choppy. We have to constantly remind ourselves that recoveries following financial crises are typically long drawn affairs. This one is no different. With the deleveraging still ongoing, it will be a while before the economy returns to a more sustainable equilibrium level of employment. Meanwhile, the markets will continue to require validation through economic data. Consequently and commensurately, the re-rating process will also be long drawn and choppy.

As for China, markets remain pessimistic as indicated by the continued underperformance of Chinese stocks, emerging equities and currencies as well as industrial metals. Investors were spooked by the Chinese government’s target of 7.5% GDP growth and worried about an economic hard landing. We believe those concerns are overblown. The lowered target reflects a shift away from growth at any cost to a desire to seek a more balanced and sustained economic growth path through rebalancing away from external demand to domestic consumption. Our view is that policy easing and rising real incomes as well as the transition to a new political leadership will be supportive of this rebalancing. But as usual markets will tend to overplay this worry until the new paradigm is validated.

Fundamentals aside, the tail risks of an oil shock from Iran’s nuclear intransigence and a financial meltdown in Europe have receded. Oil prices may be at elevated levels, but a diplomatic resolution could quickly push premiums down. For Europe, we maintain that it is best to view the debt crisis as an ongoing one. The process of adjustment, deleveraging and convalescence will be long drawn and choppy with episodes of backsliding. This may force risk premium to stay higher than normal but from where we are today, there is still room for the risk premium to fall.

Therefore, all things considered, we view the recent market consolidation as temporary and probably necessary to move on to the next phase. While we do not expect the next phase to be as strong as the recent months, we retain our constructive portfolio stance to risk assets. Specifically, we continue to be overweight in equities and credits. Our equity exposures are currently concentrated in the US and Asia while we run market neutral strategies in Europe. In fixed-income, we favour selective high yield corporate bonds as well as Emerging Market debt but we stay very defensive with regard to duration. We are also keeping some exposure to gold and alternatives for diversification purposes. Our underweight allocations are on government bonds - nominal and inflation-linked. While we are not ready to call for a bear market in bonds given the accommodative bias of the major central banks, current yield levels are just plain unattractive from a risk-reward perspective. 

In many respects the investment outlook for 2012 looks distressingly similar to the final months of 2011. That is to say the challenges and outcomes will remain dominated by concerns of the past year, namely the Eurozone crisis and doubts about the sustainability of the global recovery. The implication is that financial markets will remain largely range-bound and characterised by elevated levels of volatility and unusually high correlation amongst risky assets.

2011 was not a great year for investors. Global equities lost 10%, giving back all of 2010 gains, and to be only partially offset by a 5% return on global fixed income. Commodities were down 8% while the credit component of spread products suffered significant losses. The world economy grew at a sub-par 3% in 2011, less than the 4% of 2010.

2012 is starting out to be rather similar. In terms of economic outlook, the consensus forecasts suggest another 3% global growth. Despite a modest re-acceleration in the US, the global economy will remain hamstrung by slowing growth in China and India, mild recession in parts of Europe and an anaemic recovery in Japan.

The bright spot now seems to be in the US where we are seeing cyclical improvements in manufacturing, consumer confidence and the labour market. It looks likely that US growth will top the 2% consensus forecast for 2012. Still, the structural forces of deleveraging of the household, banks and state governments will continue to hold back growth potential. Moreover, partisan politics is likely to prevail through to the November Presidential election, preventing meaningful progress in fiscal and regulatory reforms until 2013. 

The outlook for the Eurozone is rather dim with consensus forecast of a mild recession in the first half of 2012 and recovering later to close the year flat. Worsening the outlook is further fiscal tightening and more restrictive credit conditions. The risk is clearly on the downside. Also, the private sector which is one of the few bright spots in Europe could be severely hampered if the flow of credit is disrupted by continued stresses in the banking sector. 

Japan is still plagued by anaemic growth notwithstanding government spending to repair the damage wrought by last year’s earthquake and tsunami. The strong yen continues to hamper Japan’s large multi-national corporations which are heavily reliant on exports. Adding to this, the ruling Democratic Party of Japan has been largely ineffective in tackling economic issues as it is busy grappling with an internal revolt over its decision to raise the consumption tax from 5% to 10% by 2015 risking the chance of a snap election in 2012. 

And in most emerging economies, growth is likely to slow in the first part of 2012 due to the lagged effects of policy tightening as well as the adverse impact from the Euro crisis. This has the effect of negating the positive momentum in the US. However, with inflation peaking, we believe some of these countries such as China and Brazil will reverse their tight policies in the first half of 2012 to refocus on growth.

Besides economic doubts, the more pressing issue continues to be the Eurozone sovereign debt crisis. After what seems like a never-ending stream of summits in 2011, policymakers in the Eurozone have yet to find a lasting solution. Investors continue to be worried about the government funding needs this year – Eurozone governments will need to refinance more than €1 trillion of maturing short-term and long-term debt in 2012. The focus is now squarely on Italy which many consider as too big to fail and hence a real test for the crisis. With yields on Italian 10-year bonds above 7% and Europe's bailout fund having to offer higher interest rates than in the past to place €3 billion of debt, markets will continue to be vexed.

All said we believe the problems of 2011 – doubts about global cyclical recovery and the euro-zone structural debt crisis – will continue to pre-occupy investors’ minds and remain a source of sharply shifting risk premiums in the initial months of 2012.

However, it is also important to note that in several respects 2012 is different from 2011. For one, market prices have already factored in most of the current woes. The US 10-year Treasury yields have dropped more than 100 points in 2011 and are now trading just below 2%. Gold is some 13% higher while equities are anywhere between 10-30% lower, except for US equities which closed 2011 just about flat. During the year, global corporate earnings continued to grow by 5% which means price-to-earnings multiples have fallen even more and are now at levels similar to the first quarter of 2009 before the market recovery.

True, these levels do not matter much if global risk premiums continue to rise because of the unabating macro and event risks. But it does suggest a couple of things. First, the winning strategies of 2011 – US Treasuries, high-grade bonds, precious metals, JPY, CHF and the US dollar – look less compelling at current levels. Second, should these macro risk factors start to recede, the scope for a massive rebound is good especially coupled with a market positioning that is still highly defensive. 

The second difference is inflation. For most of 2011, emerging markets (EM) especially in Asia and Latin America were battling rising commodity and asset prices – a result of the massive domestic credit expansion as well as capital inflows from developed economies. Policymakers in these emerging markets tightened policies and allowed their currencies to strengthen fuelling hard-landing worries and resulting in massive underperformance in their equity markets. In the final months of 2011 however, inflation seemed to have peaked and asset prices started to correct. Some, like Brazil, Thailand and Indonesia, have started to cut key interest rates while most have also allowed their currencies to depreciate against the USD. In China, policymakers have cut banks’ reserve requirement ratio and started to focus on growth initiatives. The expectation of a stabilisation in EM growth together with a more durable US recovery could potentially offset the negative impact of a Eurozone recession provided it is shallow and temporary.  

For these reasons, 2012 should turn out better for risk markets albeit with continued volatility. We expect a reversal of 2011’s performance which started out strong and then crashed. 2012 will instead start with a surplus of pessimism and defensive positions, with upside surprise in the second half from receding risk of a Eurozone break-up and a more durable global recovery.

The implication for our asset allocation is to continue with an underweight stance in government bonds (both nominal and inflation-linked), a slight underweight in equities and overweight in corporate bonds and precious metals.

When we will start to become more positive on risk assets will depend largely on the evolution of macro risk factors which include stress points in the Euro-zone, China real-estate and US fiscal policy as well as the strength and sustainability of the global cyclical recovery.

Of the various risks, a break-up of the Eurozone ranks as the highest risk because of its size, leverage and inter-connectedness. It could potentially dwarf the impact of the Lehman collapse. With the benefit of hindsight, our current view is neither a dissolution nor an instant resolution. Instead, as German Chancellor Angela Merkel suggested, the move towards a resolution is like running a marathon. It will be incremental with many setbacks. Unfortunately this timeframe doesn’t sit very well with investors who are getting impatient causing shifting risk premiums in the markets.

The correction in Chinese property market is a concern given the export and manufacturing slowdown at the same time. However, the current slowdown has much to do with policy tightening and can arguably be reversed. As for the property market, the current leadership left no doubt that they are bent on pricking the bubble before it could impose more deleterious effects on the economy like in the US in 2007-2009. We believe they will continue to micro-manage the sector with administrative tools while allowing for looser monetary and fiscal policies to tackle the economic slowdown. This is definitely a risk factor we do not want to underestimate or overplay but must be monitored closely. On the US fiscal issue we see the standoff between the two political parties as continuing to the November Presidential election but with neither side risking a collapse.

All said it is too early to abandon the defensive position. Stay tactical and there should be opportunities to redeploy some time during this year.

US Congressional supercommittee fails to agree on plan to reduce deficit

At a time when contagion risk from the European debt crisis is still brewing, global economic momentum waning and confidence plunging, these Congressional leaders responsible for restoring confidence in the US state of fiscal health have decided to put politics ahead of the economy.

The failure does not mean that the US will not cut its deficits because there is an automatic spending cut or “sequester” rule that will start in January 2013 for ten years. It just means that both the Republicans and the Democrats have squandered a golden opportunity to strike a compromise to restore the country’s finances and also to demonstrate leadership to the world.

Under the sequester rules, roughly half of the spending cuts would come from defence and homeland security, and the other half from domestic programmes such as roads, education, energy and housing. An automatic cut from every federal agency is far from an ideal way to manage a budget, because it does not set priorities and largely exempts the major entitlements like Medicare and Medicaid. In other words, as President Obama has said, the deficit would be trimmed with a “hatchet instead of a scalpel.”   

So far rating agencies S&P and Moody’s have said they won’t lower ratings on the US despite the supercommittee’s failure and bond yields haven’t reacted much even though stocks continued to plummet. Perhaps from the go it was considered a long shot and optimism was never high that the panel would succeed given the proximity to the Presidential election next year. 

Still the outcome depressed market sentiment further at a time when confidence in political leaders to find solutions to the world’s problems is waning. In fact, in some countries, politicians are seen to be the problem. These feelings have given impetus to movements like the Arab Spring, Occupy Wall Street etc. to agitate change from the bottom up. In more democratic countries like Greece and Italy, incumbent administrations have made way for more technocratic governments.  

The world is in dire need of leaders who are operators with an understanding of economic issues and market solutions, and not mere career politicians. With economies slowing, unemployment high, workers taking to the streets, it is not far-fetched to imagine technocratic governments even in France and Germany in the near future. 

Or perhaps the fault lies with the system rather than the people. Democratic capitalism seems to be ill-placed to deal with the economic crises in both the US and Europe where politicians cannot see beyond their partisan stance for the greater good. Perhaps if either Europe or the US had an autocratic system, their leaders could have accomplished much more. This is only hypothetical and I do not want to start a debate about whether democracy or autocracy is the better model. Ultimately, it is about governance and it is about both the structure and the people in it.

To conclude, we believe that political risks and policy risks will remain elevated and continue to drive the markets into 2012. It is tough to be bullish in such an environment.

Greek Referendum Throws a Spanner in the Works

Greek Prime Minister George Papandreou's call for a referendum on the freshly minted bailout package rattled global financial markets as officials and investors panic over the possibility of a collapse of the euro-zone.

After what seemed like a Sisyphean task to hatch a comprehensive plan to deal with the sovereign debt crisis by European leaders, Greece’s shock decision late Monday to hold a referendum threatens to unravel all the goodwill mustered over the past few days.

Essentially, Mr. Papandreou is asking his countrymen to decide if they wish to accept the debt deal that will require Greece to implement all the austerity programmes forced upon it by the “troika” (EU, ECB and IMF) for at least a few years in return for continued funding. But effectively, the referendum amounts to a vote on Greece remaining a member of the euro-zone and could potentially lead to a disorderly default of its debt.

The referendum is not expected to be held before December and current opinion poll suggests 60% of Greeks oppose the deal. Many things can still happen between now and then. Mr. Papandreou is already facing revolt within his own Pasok Party and a confidence vote against him may be in the works. Or perhaps, he can persuade Greeks that their best option remains within the euro-zone.

This brings home the point that when push comes to shove, Greece can still reject the deal, exit the euro and reclaim their sovereignty. While this may not be such a bad option for Greece, coming at such a tense time could fuel concerns about the viability of the entire euro-zone.

In one broad stroke, Greece has lost the goodwill from European leaders and the bailout package is held hostage by Greek voters. The sixth tranche of the aid disbursement to Greece is now in jeopardy while countries such as China and Japan would surely have second thoughts about risking their taxpayers’ money to invest in any bailout fund.

Our recent upgrade of equities was premised on Europe avoiding a messy, disorderly default of Greece. We had that for a few days last week when leaders agreed to a 50% haircut on Greek debt, enlarging the EFSF to EUR1 trillion and forcing banks to recapitalise their core capital ratio to 9%.

With the Greek referendum on the cards, we are back to square one with the tail risk of a disorderly default on the radar again. Worse, this looks like a binary outcome and it is not in the hands of the politicians. Strange, for once, I’d rather it is in the hands of politicians. Now, it is down to a flip of the coin.

There may be some reprieve from the G-20 summit this weekend. But as long as the tail risk remains elevated, we will lighten up at every opportunity.

Is there a silver lining? Yes, but that’s a topic for another time.

Finally, a deal! Tail risk of a disorderly Greek default dissipates.

European leaders have finally delivered what looks like a comprehensive plan to manage its sovereign debt problems from spreading to bigger economies such as Italy and Spain and to avert a possibly ruinous banking crisis.

After what seemed like days and hours of deadlock and brinkmanship at the EU ministerial summit, significant progress has been made on three key areas, even if key details are lacking.

On the Greek situation, officials have managed to persuade bondholders, especially banks, to take 50% losses on their holdings of Greek government bonds.

This paves the way for European banks to recapitalise their dented balance sheets to an agreed target of 9% in Tier 1 capital ratio by 30-Jun-2012. The European Banking Authority estimated banks’ capital needs at EUR 106 billion, with Spanish banks requiring EUR 26.2 billion and Italian banks EUR 14.8 billion. It gave them until 25-Dec to submit money-raising plans to national supervisors. Banks that fail to raise enough capital on the markets will first tap national governments, falling back on the EFSF rescue fund only as a last resort.

Finally, they have also agreed to expand the firepower of the euro zone's bailout vehicle, known as the European Financial Stability Facility (EFSF), by four- or five-fold suggesting it could provide guarantees for around EUR 1 trillion. Details are still sketchy but turning this fund into a bank with a credit line from the ECB has been squarely rejected by the Germans. It is likely that the EFSF will be used to insure bond issuance by affected countries, and to create a special investment vehicle that would tap money from both public and private investors within and outside of the euro-zone. 

What does it mean for equities and risk assets? After two months of de-rating driven by perceptions of sovereign defaults and systemic banking risks, we expect the equity risk premium to fall as the tail risk of a disorderly Greek default and banking crisis have been averted. This suggests that the rebound in risk assets that has been underway in recent days may well continue for some time.     

Therefore, we upgrade our tactical assessment of stocks from underweight to neutral. This translates to a three percentage points increase equities in our conservative profile to 18% and five percentage points for balanced and growth profiles to 35% and 55% respectively.

However, we remain cautious in the medium term for a few reasons. For one, it is still critical how all these will be turned into detailed points of action and implemented in the coming weeks. But more importantly, the global macroeconomic outlook remains weak and policymakers having already spent most of their options can't do much about it. Also, investors may just return to focus on the US and the dysfunctional government there just doesn't inspire much confidence either. 

Promising or Just Promises?

Europe appears to be finally gaining momentum in its long and slow struggle towards a solution to the sovereign debt and banking crisis that is threatening its very existence. France and Germany have promised to produce a “comprehensive plan” to end the crisis at this weekend’s European summit on 23-Oct and will present it at the G-20 ministerial meeting on 3-Nov. The plan is expected to encompass three crucial elements: deeper haircut on Greek debt; recapitalisation of European banks; and an increase in the firepower of its bailout fund to prevent contagion to other countries.

Sounds familiar? Sure. The markets have been demanding these actions for some time while politicians were dithering. What is new now and certainly out of character is that a definitive timeframe has been fixed and one that is rather aggressive too. All of a sudden, policymakers in the euro-zone find themselves surfing right up to the curve as markets turned decidedly exuberant in anticipation of a resolution.

Is this the real deal? This is a tough call. That Germany and France have promised to act within such a tight deadline is promising. And markets have rewarded such a bold move with the EUR trading at a 1-month high and equities up more than 10% in the past two weeks. But the devil is in the details and the proof of the pudding is in the execution.

Regarding the amount of haircut, there is still disagreement amongst various countries to accept deeper losses. It was only three months ago that private creditors agreed to a 21% haircut. Germany now wants a 50%-60% write-down while France is resisting because French banks, being one of the largest holders of Greek debt in the region, will be hardest hit. What should the amount be? Too little and the markets will be disappointed. Too much and it will encourage Ireland and Portugal to backslide on their reforms and clamour for a haircut too.

On recapitalisation, what is clear is that banks need more capital. Besides that, little else is clear. There will be new stress tests to determine the extent of additional capital the banking system needs. The stress test scenarios have to be tough enough to be credible but yet at the same time not so demanding that the capital needed to fill the gap is unachievable and risk sending the markets into another tailspin. According to sources, EU leaders are working on a plan to raise anywhere between EUR100 billion and northwards of EUR300 billion. Meanwhile, banks are reluctant to raise capital when their shares are trading at fractions of book value, existing shareholders are resisting calls to pump more capital and governments are weary about using more taxpayers’ money to bail out banks. It is also unclear whether the recapitalisation will be a piecemeal effort on a national basis or a concerted pan-European execution in one go. Germany has stressed that individual countries should take care of its own but France is opposed to that because it could jeopardise its triple-A rating. 

And on more firepower to the EFSF bailout fund, one can only hope that they have achieved a consensus. It is only after a prolonged struggle did the German parliament finally ratified the expansion of the EFSF to EUR440 billion and allowed it to buy bonds in the secondary market as well as to offer credit lines to governments. The same can be said for Finland, the Netherlands and Slovakia. If the EFSF is to be sufficient to backstop the liquidity of the periphery countries including Spain and Italy, it would need to grow to a size of at least EUR2 trillion. And EUR2 trillion implies a coverage ratio of only just about 50%. European officials have to find ways to scale up the fund without requiring another round of voting. They could either turn the EFSF into a “bank” allowing it to leverage up its equity of EUR440 billion through a credit line with the ECB, or alternatively, it could act as an insurer to protect the first 20%-30% of the value of affected sovereign bonds. It is unclear how they will proceed.

One week is a rather short time to manage all these challenges. But then again, this crisis has been brewing for more than a year and a half. With pressure mounting, time running out, European politicians have no more excuses. For once, they have the chance to get ahead of the curve. They should grab it. 

The big question is will they succeed in convincing the markets, or will they disappoint yet again. If the latter, then markets could easily give back all the gains and more, but if the former, then the question is how much more upside can there be. Going by the previous experience in the US in 2009, it can be substantial. In March-2009, US Treasury Secretary Tim Geithner expanded the TARP program to announce a public-private initiative to buy toxic assets from banks paving the way for the banks to be recapitalised. That turned out to be the turning point in the risk markets and equities powered ahead for the next 12 months by more than 80%.

I’m not suggesting we’ll get a similar magnitude of response. For one, while the TARP in 2009 may have removed the systemic risk threatening the banks, the real lifting of financial markets was attributable to the combined global firepower in fiscal and monetary stimulus and quantitative easing.

The world is a much different place now. Governments in the developed world are on an austerity mode even while their economies are moving along stall speed, and central banks do not have much room for manoeuvre with rates already at or near historic lows. The experiment with unconventional policy such as quantitative easing have not yielded much in terms of economic growth but have definitely bloated up the balance sheets of these central banks. And more importantly, investors are less naive. They now know better that you can’t solve a debt problem with more debt. It only comes back to roost at a later time.

For the record, I’m not a pessimist. In fact, as an equity fund manager, my pre-disposition is normally optimistic. I believe we’ll get a strong rebound when we get the resolution. But given the reality, I’m just not as convinced about the sustainability. For me, the best case scenario is that the European crisis is stabilised, developed markets manage a 1-3% annual growth while finding a way to reduce their debts over the medium term without harming the economy too much. But the odds are not high and hence we need to be prepared for a “new normal” in the financial markets with higher volatility and lower returns. This will have strong implications on asset allocation in the next few years. In a high risk-low return environment, the sweet spot in terms of risk profile is skewed towards the conservative. But for now, even though we are cautiously optimistic, prudence would dictate that we change our allocations only when we get more clarity on 23-October.

Asian Equities Held Hostage to External Circumstances

Why so weak?

Asian equities have underperformed since the middle of August as structural problems with the fiscal health of the US and the EU returned to haunt the markets. Once again, Asian and other Emerging Markets (EM) stocks have reverted to their status as the whipping boy when systemic risks rise globally.

 

While the trigger of the weakness was mainly due to external factors, the magnitude of the sell-off especially in the recent two weeks can be traced to positioning. Since the Global Financial Crisis (GFC), investors have piled onto EM assets with impunity. Non Foreign Direct Investment (FDI) capital inflows into emerging markets are at 15-year highs as weightings in market indices gained more prominence for global asset allocators.

It is also understood that the bulk of these investments into the EM were not FX-hedged because of the expectations of currency appreciation due to stronger fundamentals and the need for stronger currencies to contain imported inflation.

In particular, Asian equities have benefited massively from such inflows in recent years as investors are drawn to substantially higher earnings growth as compared to developed markets. Hence, a reversal under current conditions can only exacerbate the magnitude on the downside as investors seek safety and sell both securities and Asian currencies to repatriate their USD money flows.

Impact of capital markets volatility – how it will continue to depress Asian markets

In the near term, sharp market correction posits two immediate impact - margin calls on client positions leading to curtailment of collateral and margins, exacerbating the downside in the near term especially for mid and small-cap stocks, and weaker banks’ earnings, arising from lower client driven capital markets’ activities, lower proprietary positions and higher NPLs. This portends a credit crunch in our view as falling market values force banks to tighten credit further leading to a vicious circle of liquidation.

Value remains undervalued

Where do we go from here? Asian markets have already corrected massively and more so than the US and Europe while valuations have dropped to 10x forward PE vs. 2008 lows of 9x. In terms of value, Asian stocks certainly look attractive. But value alone is an insufficient condition for a sustainable rebound. We need a clear resolution to the European debt crisis. Only then can the markets revert to fundamentals and valuations. In the absence of a resolution, positioning in EM and Asia warns against jumping back into the markets too quickly.

Markets inflexion point will be defined by capital raising/M&A by EU banks

 
Just as the macro events in the developed economies are key culprits for the sell-down in Asian markets, an enlargement of the EFSF and/or a capital call / M&A activities by EU banks should conversely signal an inflexion point in the capital markets cycle.

Expanding the EFSF bailout fund from EUR440 billion to EUR2 trillion should be sufficient to act as a firewall against further contagion in the fiscally weak Europe periphery, while the recapitalisation of European banks will prevent another system-wide credit crunch. Based on IMF’s estimates and assuming 50% write-offs on Greek debt, we postulate at least EUR200 billion is needed for the recapitalisation of the EU banking sector to allay investors’ fears.

Only when the EU banks complete their capital raising (and thereby strengthening their capital position), would investors be more receptive towards potential Chinese policy stimulus, re-expansion of the US Fed's balance sheet, and re-accelerating global growth momentum. Failing which, even with a well-armed EFSF, the EU and developed markets financial sector is likely to enter into a static credit phase, which will manifest itself in economic contraction wrought by financial de-leveraging. We will be patiently waiting for signs of the above inflexion points to redeploying our cash.

The Asian Crisis of 1997-8 and the recent US experience during the 2007-8 Global Financial Crisis (GFC) present valuable lessons on inflexion points. Sovereign defaults were a common theme amongst the Asian economies then as massive devaluations in Asian currencies precipitate massive recapitalisation and numerous M&As in the banking sector as non-performing loans and assets ballooned to almost 20% of the system. In 1998, Malaysia set up Danaharta, an asset management company to remove bad assets from banks’ balance sheets and also, it established Danamodal the same year to facilitate the recapitalisation of banks. In Thailand, the Thai Asset Management Company was set up to handle non-performing assets, similarly Indonesia set up Indonesian Bank Restructuring Agency (IBRA) in the same vein. The Financial Supervisory Service (FSS) led an intensive restructuring of the Korean financial industry. Over a six-year period extending from 1998 to 2003, 840 financial companies – including 14 banks – were removed from the Korean market through M&As or liquidation. Despite these efforts, NPL ratios across Asian countries remained in high double digit until 2004, some 7 years after the onset of the Asian Financial Crisis. Singapore banks, which were the best capitalised with Tier 1 ratios averaging 16% then, saw consolidation in the industry from 6 to 3 banks (between 1998 to 2001). And in the US, at the height of the GFC, it set up the USD700 billion Troubled Asset Relief Program (TARP) to recapitalise its banking system. These examples illustrate the need for an asset management program complete with a recapitalisation model in times of severe economic crisis and we believe that the EU is no different in this regard