Close up on the Far East

Friday, 24 April 2009 12:11

China and neighbouring countries have certainly not remained immune to the recession

by Jean-Charles Sambor, Senior Vice President of Emerging Markets Research and member of SGAM’s Strategy and Economic Research team, Société Générale

In 2008, we had three strong convictions regarding Asia markets: (i) Asian exports would tumble; (ii) the Asian equities decoupling story was a myth; and (iii) Asian inflation was temporarily being driven by soaring commodities prices but would have to go down significantly. In 2009, we expect that (i) Asian growth will continue to decelerate quickly, driven by a simultaneous decline in all GDP components (investment, consumption and exports) - it will not be a collapsing export story only; (ii) Asian inflation will continue to fall rapidly with some significant country specific deflation risks; and (iii) Asian markets are unlikely to rally as long as global risk appetite remains depressed. Still we continue to see some interesting investment themes on a very selective basis, especially in China.

A Gloomy Macro Outlook

The sharp slowdown in Asian growth will continue, and it will be painful. More disappointments in China are very likely in the first half of the year, especially on the export and private investment fronts despite the recent acceleration in credit and money growths. Overall, Asian growth is likely to reach 3/3.5% only with Chinese growth falling to around 6.5/7% (significantly below the official target of 8%), and Indian growth also moderating to around 5%. Counter-cyclical fiscal policy will provide some cushion for the sharply deteriorating growth outlook, but few countries in Asia can afford broad-based fiscal stimulus. China has better resources than most emerging markets to prevent a long-lasting hard landing, but it will not be sufficient to save the entire region.

Inflation has been falling sharply across Asia, driven mainly by collapsing food and energy prices. We expect average inflation in Asia will fall toward 2% in 2009 (much less if we remove India, Indonesia and the Philippines from the list), led by significant overcapacity. We anticipate aggressive interest rate cuts will continue in most Asian countries, even ones with persistently high inflation such as Indonesia and India.

On the currency front, the global deleveraging has been the dominant driver of financial flows, and has generated much stronger exchange rate correlations across emerging market currencies. Although we expect Asian currencies to remain weak against USD in the short term, as long as global demand for Asian goods remains depressed, the region’s exporters will not benefit from gains in price competitiveness. Asian currencies might appear undervalued, but a broad-based rally is unlikely in the short term even though fundamentals have not materially changed.

Finally, we expect the RMB to remain stable against USD. We do not buy the sharp devaluation scenario for at least four reasons. (i) First, a weaker RMB would have little impact on exports. Chinese exports do not suffer from a lack of competitiveness, but rather from the sharply contracting consumer demand globally. (ii) If China were to devalue its currency, the risks of competitive devaluations across Asian countries are real and would bring back painful memories of past global recession episodes. (iii) Devaluing the currency would accelerate the pace of capital outflows from China, which would be a disaster as China tries to revamp its financial markets. (iv) Finally, this could trigger a significant protectionist backlash from the US and the EU.

No Broad-based Rally but Some Selective Opportunities

In our view, it is still too early to play two well-known fundamental themes in Asia: (i) Asia will account for the vast majority of global growth in the years to come, even under an Asia hard landing scenario; (ii) balance sheets of Asian sovereigns and corporate are among the strongest in the emerging markets universe. Once global risk appetite returns, the rally in Asian markets will likely outperform both G7 countries and other emerging market regions -we are clearly not at this stage yet. In the short term, the irony is that the macro future of Asia’s financial markets is not in Asian hands.

Although we are convinced that a broad-based Asian rally is unlikely as long as global risk appetite remains depressed, some regional macro themes are expected to play a significant role in determining Asian prospects for 2009. The meltdown of 2008 was undiscriminating – all countries suffered, across all sectors. With Asia’s macro outlook expected to deteriorate further in coming months, divergent sector performances should once again play a key role in the search for new investment opportunities. In this piece we focus our attention on a specific one: Asian fiscal stimulus efforts, and its impact on stock market performances, especially in mainland China.

Monetary and fiscal stimulus efforts in most Asian countries are much more recent than in the United States. It is too early to tell whether the attempts to partially cushion the blow from sharply contracting exports will succeed. In any case, the potential positive impact of the fiscal stimulus on infrastructure-related asset prices is not currently fully priced in by the markets, not because of investor scepticism, but rather because it is still very new and tenuous. Broadly speaking, Asian Central Banks only started cutting rates five months ago, roughly one year after the Fed’s easing cycle began, and fiscal stimulus packages were only announced across Asia over the last couple of months.

Most Asian countries still have plenty of monetary stimulus ammunition, and we expect even more aggressive rate cuts and bigger than expected fiscal packages down the road. Moreover, most of this fiscal stimulus has not been fully disbursed yet (16% of GDP in China. We remain sceptical about the amount of new money in this package - 8% in Singapore, about 4% in Taiwan, Korea and the Philippines, and around 1% of GDP in more fiscally-constrained countries such as India, Malaysia, and Thailand).

Implementing success

The ultimate success of these new measures will depend on the traction they receive and the timing of implementation on a country specific basis. Moreover, China’s fiscal stimulus will be key in this regard; not only because of its sheer size and because other Asian countries are much more fiscally constrained, but also because it is being disbursed earlier than others. Beyond the direct fiscal stimulus, China is one of the rare countries which had launched – and can afford to launch – industry specific measures (especially in the car industry, real estate and banking sectors). While we remain sceptical about the final impact of these measures, we acknowledge that China is better-positioned than most emerging markets to implement such a massive and broad-based stimulus. We are also aware that the short-term boost will not come without medium-term costs: declining efficiency of investment, further distortion of China’s growth profile and higher NPLs down the road. Still stimulus is stimulus and China has much more firepower than any other country in this regard.

Should China manage to at least partially cushion the negative impact of the financial crisis through these various stimuli, it is unlikely to trigger a broad-based Asian equity rally. Instead, we would anticipate a significant outperformance of infrastructure-related stocks, ranging from utilities to materials. Over the longer-term, but over the longer term only, the acceleration in social reforms should help decrease precautionary savings and boost consumption. However, in the short term, we continue to expect Chinese domestic consumption will fall in the first half of 2009 and Chinese growth will be driven mainly by public investment.

The sharply decelerating inflation should also benefit infrastructure-related stocks in China. Despite much lower demand on the back of sluggish economic growth, these sectors have been more resilient than others as input prices have also tumbled. A rapid disinflation process, not a regional deflation scenario, should help these sectors. If the disinflation process deteriorates into prolonged deflation risk, very few sectors will be deflation-proof. Even so, these sectors should outperform others as they would benefit from relatively sticky output prices (fixed or contracted prices) and less cyclical revenues. Overall, this infrastructure play appears set to benefit the most from the fiscal stimulus, and yet seems to be the least exposed to deflation risk.

Asian growth and inflation are collapsing. The worst is not behind us. Overall, the fate of Asia still lies in far away hands. We expect no broad based rally as long as global risk appetite remains depressed. However, we expect more discrimination than in 2008 and more discrepancy among sectors. Infrastructure-related assets are likely to outperform under this scenario of rising government investment spending combined with rapid disinflation. Under such a scenario, China is likely to outperform other Asian countries.