Note where Malaysia stands!!!!
- 11-11-2008: 2009 should not be 1998 deja vu
By Morgan Stanley Research
Investment case
The Asia-Pacific ex-Japan equity index has declined as much as 65% from the October 2007 peak, a larger decline than in the Asian crisis of 1997-1998, or in the TMT bust of 2000-2001.
Valuation is well below the trough levels of the Asian crisis, Asia’s deepest modern downturn. To assess the prospects for Asian markets in the current global downturn, we compare Asia’s current fundamentals to those in the Asian crisis, the most relevant benchmark given Asian markets were undeveloped in the Great Depression or the 1970s. We conclude that Asia is far better placed than it was in 1997 to withstand a financial crisis, and that China is best placed within Asia.
APxJ equity valuation is a record low, far below Asian crisis trough levels
APxJ is at a record low on 11 of our 12 valuation metrics. The forward P/E, trailing P/E, and dividend yield are 17%, 37%, and 41%, respectively, below the average of the prior four market troughs. Whilst P/BV is well above the Asian crisis low, ROE is still substantially higher.
Even if we exclude Australia and New Zealand, both of which largely avoided the Asian crisis, the valuation is still more attractive than at the trough in September 1998. Indeed, forward and trailing P/Es are 8% and 49% below the trough levels, respectively, whilst dividend yield is 12% more attractive.
Again, while Asia ex-Japan’s P/BV is still 39% higher than at the Asian crisis trough, only 11 months in the past 29 years have seen a lower valuation.
Furthermore, the current AxJ ROE is well above the level at the crisis trough, at 14.9% versus 4.3%.
Differences between today and 1997-1998
1) The rise of China and India
A key difference between Asia today and in 1997-1998 is the emergence of China as a key driver of growth. Since 1996, China’s share of regional GDP has grown from 25% to 44% (2008), while India’s share has increased from 11% to 13%. By contrast, the rest of the region has fallen from 64% to 43%, led by Korea and Taiwan, falling 10 percentage points (ppt) to 14%, and Asean, falling 7ppt to 14%. With China never more important, its ability to engineer a soft landing is critical to Asia’s growth outlook.
2) Strong external sectors: Trade balance; FX reserves
Unlike 1997, Asia’s external sector is in substantial surplus, reflective of a more diversified direction of trade (the US is at a record low 14.6% of Asia’s exports), more diversified export base, competitive exchange rates, high national saving rates, strong investment in export industries and, until recently, strong global growth.
Asia’s export performance has been robust, up 20.6% year-on-year (y-o-y) in 3Q08, led by Korea, China, India, and the commodity producers of Australia, Indonesia and Malaysia. Singapore and Taiwan have lagged.
Current account balances have improved significantly from -US$28.2 billion (-RM100.11 billion) in 1996 to US$525 billion in 2007 (7.4% of GDP) and are expected to stay at a large 5.6%-5.9% of GDP in 2008-2009. Foreign exchange reserves have risen from about US$500 billion in 1997 to more than US$3.3 trillion. The external balance is strongest in China, Singapore, Taiwan, Malaysia, and Hong Kong, and weakest in Australia, India, and Korea.
In the current global financial crisis, Asian central banks have begun to utilise their FX reserves to defend their currencies and support their banking systems. Korea, for example, has intervened in its FX market and injected US$30 billion of liquidity into its banking system from its foreign reserves. Backed by FX reserves, Singapore, Hong Kong, Malaysia and Taiwan have guaranteed their bank deposits. Hong Kong has also indicated its intention to use its FX reserves to stabilise financial markets should the need arise.
3) Ample scope for policy response
In the 1997-1998 Asian crisis, IMF austerity programmes were imposed on Thailand, Indonesia, the Philippines and Korea, requiring a substantial tightening of monetary and fiscal policy. In this cycle, however, IMF rescue plans are being implemented in Eastern Europe’s Hungary, Ukraine and Iceland.
By contrast, Asia is currently aggressively easing policy, a trend we expect to continue given Asia’s strong fundamentals. First, high headline inflation, a reflection of the commodity boom, should continue to decline sharply. Indeed, key commodities are now well below 4Q07 levels, including oil (-25% y-o-y), the MGMI base metals index (-38% y-o-y), wheat (-34% y-o-y), palm oil(-32% y-o-y), soybean (-17% y-o-y), ethylene (-55% y-o-y), and naphtha (-61% y-o-y), while corn (-2% y-o-y) and steel (China HRC +3% y-o-y) are about flat. Only rice (50% y-o-y) remains well above year-ago levels.
As such, we expect headline inflation to fall below core inflation, which in core Asia (Asia ex-India, Indonesia and the Philippines) is just 2.0% y-o-y, below the 1H97 average of 4.1%.
Together with Asia’s large external surpluses, low levels of leverage, and liquid and well-capitalised banking systems, low inflation should support significant policy easing to counter the global downturn. This is already happening across Asia, led by North Asia, India and Australia. With rates in the US at 1%, Asia should ease policy by another 100-200bp — our economists expect China (108bp), Korea (125bp), Australia (225bp), Taiwan (50bp), Malaysia (75bp) and Thailand (75bp) to all ease rates over the next year.
4) A commodity tax cut
Asia is now the major consumer of most global commodities, and even consumes almost as much oil as the US. With the oil price falling from an average of almost US$125/bbl in 2Q-3Q08, a US$55/bbl tax cut to US$70/bbl is equivalent to a US$385 billion tax cut for Asian consumers, or equal to 4.8% of GDP. Whilst this estimate assumes the pass-through of lower oil prices in countries with price controls like China and India, competitive pressures and the global downturn should ensure this happens in the near future. Currency weakness in Australia, Korea, and India will moderate the oil tax cut benefit. Furthermore, given Australia, Indonesia, and Malaysia are large energy producers, and Australia is very energy efficient, we would expect them to receive a smaller benefit. Whilst commodity prices also fell in the Asian crisis, the decline was far less significant. Furthermore, in that instance, Asia was the source of the demand weakness, whilst today the weakness is emanating from the US and other developed economies.
5) Modest household leverage
Household sector leverage in most of Asia is dramatically lower than in the US or UK. Only Australia, with a household debt/GDP ratio of 110%, is higher. On the other hand, China at 13% and India at 14% are dramatically lower. Similarly, consumption’s share of GDP is also far lower, and has significant room to expand.
6) Record banking system liquidity
Asia’s banking system has never been more liquid, with the bank loan-to-deposit ratio (LDR) at a record low 72%, far below the mid-1990s peak of 113%. Only Australia (143%) and Korea (140%) have LDRs well above 100%. The lowest LDRs are in Hong Kong (60%) and China (65%).
7) Strong corporate sector; low gearing, moderate capex, strong free cash flow
Asia’s corporate sector has substantially restructured over the past decade. First, balance sheet leverage has improved substantially, with leverage at a record low 32%, about half the levels of a decade ago (65% in 1996 and 74.3% in 1997). The improvement has been broad-based across Asia.
Second, capital spending in the listed sector is generally under far better control, with the capex/depreciation ratio for the region at a moderate 179%, close to the long-term average, and far below the 260% of 1996-1997. Within Asia, capex discipline appears to have been strongest in Hong Kong (capex-depreciation ratio of 158% versus a long-run average of 264%), but worst in India (ratio of 333% versus a long-run average of 228%) and Australia (240% versus 173%).
Third, free cash flow is strong at 6% of sales versus a negative 3.3% a decade ago. Free cash flow is positive across all markets, but particularly in Hong Kong and Indonesia. Altogether, returns are now far above the cost of capital at 15.2%, up from just 10.1% pre-crisis, and comparable to developed market peers.
Country ranking —Greater China best
Putting these criteria together, we have ranked the region by country, concluding that Greater China — China, Taiwan, and Hong Kong — is best placed, whilst Australia, Malaysia and India are worst placed.
If Asia’s so good,why has it been so bad?
The obvious response to this analysis is that it has been a lousy indicator of market performance over the past year. We attribute Asia’s poor performance to three key factors: rapid financial institution deleveraging, depressed risk appetite and a deteriorating earnings outlook. On financial institution deleveraging, qualified foreign institutional investors (QFIIs) have been heavy sellers in Asia since the credit crunch began. Indeed, net selling in six Asian emerging markets totalled US$93.2 billion, or 69.2% of the preceding inflows of the 2003-2007 bull market. Consistent with this, foreign ownership has fallen to at least a seven-year low of 29.4% in Korea, a five-year low of 18.6% in India, and a three-year low of 27% in Taiwan.
Furthermore, anecdotally, the gross and net investment weighting of hedge funds in Asia has never been lower.
That said, margin lending is still high in Australia at 2.5% of market cap, or 3.1% of GDP, well above the 10-year averages of 1.6% and 1.7%, respectively. Inflows into mutual funds in India [inflow of Rs300 billion (RM22.55 billion) year to date] and Korea [fund balance up 26.5 trillion won (RM73.18 billion) year to date] have remained positive. Margin lending in Taiwan, however, is at a record low 1.1% of market cap (versus an average 2.3%).
Second, global risk appetite appears to be very significant in Asia, and the collapse in the MS Global Risk Demand Index has coincided with weakness in Asia equities. Third, reflecting past cycles, the market has been anticipating the economic downturn and earnings downgrades. Indeed, the index has declined far ahead of analyst earnings revisions. With consensus earnings still at 13.8% for 2009, we too see material downside toward our base-case forecast of -1% and bear-case forecast of -21% y-o-y.
Morgan Stanley economists foresee a material slowdown in Asian GDP growth, but do not see a recurrence of 1997-1998. That said, Chetan Ahya is emphasising downside risks, pointing to the risks to exports from an EM downturn, the impact on cost of capital from capital outflow and FX weakness, and the hit from financial market instability. Against this, the support from monetary and fiscal easing and lower commodity prices will need to be balanced.
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