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