Shane Oliver: The Wild East

Key points

• Asian shares have fallen 17.5% from their May high to their June low, raising fears of another Asian crisis.
• Asian shares may have a rough ride in the short term, but are strategically attractive.

The recent sharp fall in (non-Japan) Asian shares has led to concerns about their outlook, with many fretting about a rerun of the late-1990s Asian crisis, which saw financial and economic crises spread through Asia from 1997, eventually affecting other emerging and developed markets in 1998.

Asian shares in perspective

First, it is worth looking at Asian shares from a long-term perspective. After booming during the “Asian miracle” years from the late 1980s to 1994, Asian shares then spent 12 years spinning their wheels. This is reflected in the chart below which shows the performance of Asian equities both in absolute terms (top line) and relative to global equities as a whole (bottom line), all indexed to 100 in 1988. When the (bottom) relative return line is rising, Asian shares are outperforming global shares and vice versa for falls.

Despite the big recovery since 2003, Asian shares only made it above their 1994 highs a few months ago and are well below 1990s peak levels relative to global equities.

In assessing the outlook for Asian shares, the following characteristics are worth bearing in mind:

• Asian countries have a stronger long-term real growth potential than developed countries. This reflects factors such as lower starting point income levels, greater competitiveness, rising consumer demand, and strong structural growth in China.

• Average dividend yields are traditionally low but, at 3.1% on average currently, are above those for mainstream global shares (US, Europe and Japan).

• Higher growth comes with higher risk. The Asian economic cycle and sharemarkets are more volatile than in developed markets, meaning more upside in good times and downside in bad times.

• As a big exporter, the region is highly exposed to the global economic cycle. When there are jitters about global growth Asian shares are often hit harder than mainstream global shares. Although the impact of the global cycle is falling thanks to China and rising consumer spending, this is a slow process.

• Asian and emerging markets generally tend to benefit when global liquidity conditions are easy. When Western investors are feeling optimistic and money is flowing freely they are more prepared to invest in “risky” asset classes and regions. However, when investors start to get more cautious, capital tends to flow out of Asian shares.

The recent sharp slump in Asian shares is consistent with the last three points '” when global liquidity conditions are tightening and global growth looks like slowing, Asian shares are usually hit harder than developed country shares.

No Asian crisis, but expect a rough ride short term

There are big differences between Asia today and the situation in 1997:

• First, the Asian crisis came after a long boom that was partly fuelled by foreign capital inflows. This left much of the region with large current account deficits (shown as a minus % of GDP in the next table), high levels of corporate and foreign debt, low foreign reserves, excess capacity, overvalued exchange rates, and overvalued sharemarkets. This time around the situation is far healthier. Current accounts are generally in surplus, foreign reserves are high and corporate gearing is low, foreign debt relative to GDP has fallen and Asian currencies and sharemarkets are undervalued. The region is now far less vulnerable to a 1997 style withdrawal of foreign capital.

MAsian economies, then and now
	Current account %GDP		FX Reserves, $USbn		Corp gearing ratio
	1996	Now	1997	Now	1997	Now
Indonesia	–3.2	0.4	17	38	2.4	1.4
Thailand	–7.9	–2	27	56	4.2	1.7
India	–1.6	–3.1	20	157	2.4	1.2
Korea	–4.4	1.8	20	225	3	1.3
Taiwan	3.9	5.4	84	261	1.4	1.1
Malaysia	–4.4	14.9	15	75	1.9	1.6
Singapore	13.8	26.7	73	129	1.9	1.5
Hong Kong	3.9	10.1	93	127	1.6	1.6
China	0.9	6.9	140	875	2.3	1.2
Source: IMF, UBS Investment Research, AMP Capital Investors

• Second, Asia is in far better shape than emerging markets in Eastern Europe or Latin America, which generally suffer from higher inflation, bigger budget deficits and less favourable current accounts. There is no comparison with Turkey, which has 10% inflation and a current account deficit of about 7% of GDP.

• Finally, the chart below shows those sharemarkets that rose the most over the last year have fallen the most recently. This suggests what we have seen is a classic case of investors reducing risk by selling investments that have been the most profitable. As such, the recent fall isn’t necessarily telling us to expect an Asian economic slump. Asia has performed far better than Latin America or Eastern Europe.

Asian economic growth is likely to slow only marginally over the next year as exports slow but domestic demand stays solid. However, we expect a rough ride for Asian shares over the next few months as global liquidity conditions tighten and investors remain cautious given the uncertainty about the global growth outlook. This is likely to include further declines and underperformance against US and Australian shares. However, since we don’t see a significant global or Asian growth slump we don’t see this as the start of an extended bear market in Asian shares.

Expect Asia to outperform

Notwithstanding short-term uncertainties, there is a strong case for Asian equities to outperform mainstream global markets over the next five to 10 years:

• First, valuations are relatively attractive for Asian shares compared to mainstream global shares, with both a higher dividend yield and a lower premium to year-ahead expected earnings.

• Second, Asian economies’ faster growth potential should show up in stronger earnings growth.

• Third, Asian economies are stronger than before the Asian crisis. This reflects better economic policies, trade surpluses, undervalued currencies, stronger financial systems and improved corporate governance.

• Finally, Asian share return projections for the next five to 10 years remain attractive compared with global shares. The returns below are based on starting point dividend yields along with the assumption share prices rise with nominal economic growth (as a proxy for earnings growth).

MProjected medium-term equity returns, %pa
	Div yield	Growth	= Return
US	1.9	5.2	7.1
UK	4	4.7	8.7
Europe	3.2	4.7	7.9
Japan	1.1	4	4.1
World	2.4	4.9	7.3
Asia, ex Japan	3.2	8	11.2
Australia	3.9	6	9.9
Source: Bloomberg, AMP Capital Investors

Conclusion

Notwithstanding further likely turbulence over the next few months, Asian shares remain in a period of secular outperformance relative to mainstream global shares. US shares are likely to be constrained by imbalances such as low domestic savings and a big current account deficit. Europe and Japan suffer from structural rigidities and demographic constraints. As a result, there is a strong case to use the current period of relative weakness in Asia to build a strategic exposure.