Fiddler On The Roof
By Yiannis G. Mostrous
FALLS CHURCH, Va.–It can be dangerous for investors to be sitting on positions that have achieved all-time highs. And that’s what’s happening in Asia: The MSCI All Country Asia ex-Japan Index, the region’s benchmark, recently surpassed its previous record, established 12 years ago.
Although the view may be beautiful from the rooftop, the fact of the matter is that Asia will once again be at the center of liquidation activity when investors decide–or are forced–to take profits.
Tactically, this is the reason why time was spent here during the last four weeks booking profits, either through outright stock selling or through simple profit-taking (i.e., leaving the initial investment intact).
Source: Bloomberg
I recently spent some time answering questions about the biggest risk for global markets in 2007. The answer is geopolitics.
Understanding geopolitical developments–in the age of globalization–is integral to the SRI investment process. Regional conflicts seem to be on the rise, if not in absolute numbers then certainly in importance. The Geopolitics & Investing reports are designed to identify issues of global power and explain investment implications. The long-term benefits of those reports more than justify your efforts to read or re-read them (see The Dragon And The Eunuch: Wars, Spies And Profits In 21st Century Asia and Still Playing The Great Game: Business, Investments And Politics In Central Asia).
Flash points are easily identified here in early 2007. In the Middle East, we have the insurgency in Afghanistan, civil war in Iraq, a potential civil war in Lebanon, the ongoing Palestine/Israel clash and a potentially serious problem in Iran.
The northern part of Pakistan is also quite unstable, in the sense that the region’s pro-Taliban population effectively rules the area, with the Pakistani government seemingly unable to do anything about it.
Africa is saddled with endemic problems that are gradually evolving into armed conflicts between ruthless factions (e.g., Nigeria, Somalia, etc.), which seem to spread by the day.
In Asia, we have the perennial North Korea issue: A deteriorating and desperate regime is being used for political purposes by the bigger regional and global powers.
The situation in Latin America is a bit more benign, in the sense that changes are political in nature and don’t involve armed conflicts. It may offer occasional scares and an occasional laugh, but the problems Latin America poses can be fairly easily discounted and eventually solved.
Even this cursory look at the geopolitical situation reveals that the issues are complex and serious. Although many current problems appear at first glance to be regional in nature, because they’re unfolding in resource-rich regions, they can spread as fast as fire and adversely impact the global economy.
It’s this geopolitical uncertainty that supports my long-held view that that energy will remain a secular investment theme for years to come. The energy story is supported not only by Asia’s rise as an important economic player but also by the fact that most resources are found in politically unstable parts of the world. Oil prices can, therefore, remain higher for longer; determining oil’s fair price is far more complex than taking a look at simple supply-and-demand graphs.
The SRI Portfolio has meaningful exposure to Russia because Russia remains the only politically stable, serious energy supplier in the world today–and this deserves a premium.
Narrowing it down to Asia, the biggest risk should be a potential vertigo stemming from the eventual realization that things don’t rise in a straight line. Fund flows into emerging market funds in general reached the respectable USD23 billion level, half of which went to China-related funds. For the first week of 2007, emerging market funds took in USD2 billion–the highest rate of net inflows in six months.
It’s obvious that investors are more than happy to invest in emerging markets in general, Asia in particular. The only question is if the majority understands and appreciates the risks involved. There’s a tendency among investors to talk about risk only in relation to developed markets. For some unexplained reason, they avoid talking about risk when it comes to emerging markets, perhaps because they still think of their investment positions as a short trades.
SRI is oriented to the long term and can’t afford to ignore risk. Nor can I ignore the long-term, fascinating story of Asia’s economic rise. Investors who’ve failed to understand and observe the big picture have eventually had their heads handed to them.
The Bears
The serious bearish case–distinct from the perma-bear rubbish fed by intellectual advisories for the past year and a half now–has two main parameters.
The first is the thought that the expected economic slowdown in the US could prove to be a severe recession. A more-serious unraveling of the housing market, the theory goes, will have severe negative consequences for the US consumer. It’s further argued that the financial system has become much riskier than people want to believe, and therefore, a deflating housing bubble may have wider and more-severe financial implications than is currently expected. There’s some talk of the worst crisis of the last 70 years.
The second parameter is China. The concern is that extremely strong growth has spurred high levels of inflows, which, in turn, has led to a lot of poorly conceived investment projects and created excesses. At the same time, a big part of corporate China could be facing profitability problems, given reported wage growth and a shortage of skilled labor, on top of rising commodity prices.
I have no problems with that version of the bearish argument. For starters, if there’s a severe recession, all bets are off in the financial markets. Investors who think such an outcome is highly probable should liquidate their positions in Asia and everywhere else, buy gold and wait.
For the time being, and for reasons I’ve previously expressed (see SRI, 13 December 2006, Pushing The Envelope), my view is that the deep recession scenario isn’t in the cards.
I laid out my views on 2007 in the last issue of 2006 (see SRI, 27 December 2006, SRI, Abridged II):
Asian markets could correct–substantially so–if only because of profit-taking or an attempt by investors to take a breather. More important, they could correct because of a slowdown in global economic growth, as I expect.
Indications of the latter aren’t difficult to see. Consider that Korean exports–the earliest available measure of global manufacturing activity–came in below expectations in December (13.8 percent instead of 18.7 percent), indicating the global trade cycle may have peaked. Asian exports remain a better way to gauge shorter-term changes in Asia.
Source: Bloomberg
The China argument remains a more-convincing one. It’s well known that that excess supply of capital–a problem afflicting China–leads to bad investment choices and, eventually, a readjustment period.
I don’t know when this adjustment will take place, but I’m well aware of investors’ seemingly insatiable appetite for Chinese exposure. My advice is to avoid financial stocks (banks, insurance, etc.) in China.
Asia Now
Asia remains quite attractive in relative terms, trading at 15.9 times earnings, a discount to the S&P 500’s 16.2. Return on equity–around 15 percent, up from 10 percent five years ago–remains healthy. Net debt-to-equity ratio has been steadily declining since 1998 and is currently at 20 percent, down from 85 percent during the time of the Asian crisis. The same ratios are 54.5 percent for Japan, 53.5 percent for the US and 53 percent for Europe. And Asia offers excellent dividend support, with the region’s dividend payout ratio up to 39 percent from 24 percent in 2000.
The Portfolio offers exposure to companies with the potential to give more back to investors through dividend increases, special cash distributions or share buybacks. These include Keppel Corp, Singapore Telecom, Chunghwa Telecom and United Overseas Bank.
I addressed Asian economies and their potential reactions to a slowdown in the US three months ago (see SRI, 27 September 2006, Recession Fears):
My view remains basically unchanged. The test will be more difficult for the region’s financial markets. Foreign money can dry up quite fast (as we saw during last year’s May/June selloff), and at the same time, local investors could prove unwilling to step up and buy. Taiwan was one market local investors avoided in 2006.
Investing
The long-term Asia story (as outlined in The Silk Road to Riches: How You Can Profit by Investing in Asia’s Newfound Prosperity, a book I co-authored with my colleagues Elliott Gue and Ivan Martchev) is still intact. Far-sighted investors should have serious exposure–to the tune of 30 percent to 50 percent–to the region, including Japan, depending on your individual risk characteristics and investment horizon. This allocation recommendation assumes a well-diversified portfolio, the purpose of which is to reduce overall volatility as some assets appreciate while others depreciate.
The Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent. The areas I’m looking at for investment ideas continue to be property, infrastructure, financials, retail, telecom and utilities.
Infrastructure is an extremely important aspect of the investment strategy, one I’ll detail in a coming issue. Infrastructure-related companies in the Portfolio include Cheung Kong, Keppel and Mitsubishi Heavy Industries.
Korea could be the surprise of 2007 in terms of economic and market performance. The market, the second-cheapest in Asia after Thailand, was a weak performer in 2006. And although exports are slowing, the economy seems to have more strength than previously imagined.
Given that most fund managers don’t want to own too much Korea, there’s potential for a re-evaluation if positive news emerges, because all the negative news should be priced in by now. I prefer to get Korean exposure through its banks; as a sector, they trade at a substantial discount to the rest of the region. Portfolio holding Shinhan Financial is my favorite bank in Korea.
FALLS CHURCH, Va.–It can be dangerous for investors to be sitting on positions that have achieved all-time highs. And that’s what’s happening in Asia: The MSCI All Country Asia ex-Japan Index, the region’s benchmark, recently surpassed its previous record, established 12 years ago.
Although the view may be beautiful from the rooftop, the fact of the matter is that Asia will once again be at the center of liquidation activity when investors decide–or are forced–to take profits.
Tactically, this is the reason why time was spent here during the last four weeks booking profits, either through outright stock selling or through simple profit-taking (i.e., leaving the initial investment intact).
Source: Bloomberg
I recently spent some time answering questions about the biggest risk for global markets in 2007. The answer is geopolitics.
Understanding geopolitical developments–in the age of globalization–is integral to the SRI investment process. Regional conflicts seem to be on the rise, if not in absolute numbers then certainly in importance. The Geopolitics & Investing reports are designed to identify issues of global power and explain investment implications. The long-term benefits of those reports more than justify your efforts to read or re-read them (see The Dragon And The Eunuch: Wars, Spies And Profits In 21st Century Asia and Still Playing The Great Game: Business, Investments And Politics In Central Asia).
Flash points are easily identified here in early 2007. In the Middle East, we have the insurgency in Afghanistan, civil war in Iraq, a potential civil war in Lebanon, the ongoing Palestine/Israel clash and a potentially serious problem in Iran.
The northern part of Pakistan is also quite unstable, in the sense that the region’s pro-Taliban population effectively rules the area, with the Pakistani government seemingly unable to do anything about it.
Africa is saddled with endemic problems that are gradually evolving into armed conflicts between ruthless factions (e.g., Nigeria, Somalia, etc.), which seem to spread by the day.
In Asia, we have the perennial North Korea issue: A deteriorating and desperate regime is being used for political purposes by the bigger regional and global powers.
The situation in Latin America is a bit more benign, in the sense that changes are political in nature and don’t involve armed conflicts. It may offer occasional scares and an occasional laugh, but the problems Latin America poses can be fairly easily discounted and eventually solved.
Even this cursory look at the geopolitical situation reveals that the issues are complex and serious. Although many current problems appear at first glance to be regional in nature, because they’re unfolding in resource-rich regions, they can spread as fast as fire and adversely impact the global economy.
It’s this geopolitical uncertainty that supports my long-held view that that energy will remain a secular investment theme for years to come. The energy story is supported not only by Asia’s rise as an important economic player but also by the fact that most resources are found in politically unstable parts of the world. Oil prices can, therefore, remain higher for longer; determining oil’s fair price is far more complex than taking a look at simple supply-and-demand graphs.
The SRI Portfolio has meaningful exposure to Russia because Russia remains the only politically stable, serious energy supplier in the world today–and this deserves a premium.
Narrowing it down to Asia, the biggest risk should be a potential vertigo stemming from the eventual realization that things don’t rise in a straight line. Fund flows into emerging market funds in general reached the respectable USD23 billion level, half of which went to China-related funds. For the first week of 2007, emerging market funds took in USD2 billion–the highest rate of net inflows in six months.
It’s obvious that investors are more than happy to invest in emerging markets in general, Asia in particular. The only question is if the majority understands and appreciates the risks involved. There’s a tendency among investors to talk about risk only in relation to developed markets. For some unexplained reason, they avoid talking about risk when it comes to emerging markets, perhaps because they still think of their investment positions as a short trades.
SRI is oriented to the long term and can’t afford to ignore risk. Nor can I ignore the long-term, fascinating story of Asia’s economic rise. Investors who’ve failed to understand and observe the big picture have eventually had their heads handed to them.
The Bears
The serious bearish case–distinct from the perma-bear rubbish fed by intellectual advisories for the past year and a half now–has two main parameters.
The first is the thought that the expected economic slowdown in the US could prove to be a severe recession. A more-serious unraveling of the housing market, the theory goes, will have severe negative consequences for the US consumer. It’s further argued that the financial system has become much riskier than people want to believe, and therefore, a deflating housing bubble may have wider and more-severe financial implications than is currently expected. There’s some talk of the worst crisis of the last 70 years.
The second parameter is China. The concern is that extremely strong growth has spurred high levels of inflows, which, in turn, has led to a lot of poorly conceived investment projects and created excesses. At the same time, a big part of corporate China could be facing profitability problems, given reported wage growth and a shortage of skilled labor, on top of rising commodity prices.
I have no problems with that version of the bearish argument. For starters, if there’s a severe recession, all bets are off in the financial markets. Investors who think such an outcome is highly probable should liquidate their positions in Asia and everywhere else, buy gold and wait.
For the time being, and for reasons I’ve previously expressed (see SRI, 13 December 2006, Pushing The Envelope), my view is that the deep recession scenario isn’t in the cards.
I laid out my views on 2007 in the last issue of 2006 (see SRI, 27 December 2006, SRI, Abridged II):
Though global markets had a great 2006–particularly in the last six months–the future looks a little murkier now than it did 12 months ago. For this reason alone, you should be careful to balance optimistic and pessimistic views heading into 2007: Don’t be overly bullish or bearish.
I’m cautiously bullish as I prepare to set the SRI Portfolio for next year. I expect stocks to outperform once again, but you’ll have to carefully navigate, as you did in 2006, the dangerous waters of the investment world. (See SRI, 13 December 2006, Pushing The Envelope.)
My overarching assessment for 2007 is that the global economy will slow–perhaps substantially–at some point as a natural outgrowth of the downturn that started in mid-2006. It won’t result in a deep recession, though, and global economic growth will resume.
I pay special attention to the bearish economic case for 2007 because it has merit and I agree with quite a few of its main arguments, particularly the point that a US housing slowdown is a potential contagion for that economy and, consequently, the global economy.
The bottom line, though, is that investors will be able to enjoy good returns in 2007. The key is being correctly positioned and understanding that “good performance” isn’t defined by a straight line higher. Be prepared for volatility.
I once again expect Asia and other select emerging markets to outperform developed economies. Of the latter, I prefer Europe and Japan.
Asian markets could correct–substantially so–if only because of profit-taking or an attempt by investors to take a breather. More important, they could correct because of a slowdown in global economic growth, as I expect.
Indications of the latter aren’t difficult to see. Consider that Korean exports–the earliest available measure of global manufacturing activity–came in below expectations in December (13.8 percent instead of 18.7 percent), indicating the global trade cycle may have peaked. Asian exports remain a better way to gauge shorter-term changes in Asia.
Source: Bloomberg
The China argument remains a more-convincing one. It’s well known that that excess supply of capital–a problem afflicting China–leads to bad investment choices and, eventually, a readjustment period.
I don’t know when this adjustment will take place, but I’m well aware of investors’ seemingly insatiable appetite for Chinese exposure. My advice is to avoid financial stocks (banks, insurance, etc.) in China.
Asia Now
Asia remains quite attractive in relative terms, trading at 15.9 times earnings, a discount to the S&P 500’s 16.2. Return on equity–around 15 percent, up from 10 percent five years ago–remains healthy. Net debt-to-equity ratio has been steadily declining since 1998 and is currently at 20 percent, down from 85 percent during the time of the Asian crisis. The same ratios are 54.5 percent for Japan, 53.5 percent for the US and 53 percent for Europe. And Asia offers excellent dividend support, with the region’s dividend payout ratio up to 39 percent from 24 percent in 2000.
The Portfolio offers exposure to companies with the potential to give more back to investors through dividend increases, special cash distributions or share buybacks. These include Keppel Corp, Singapore Telecom, Chunghwa Telecom and United Overseas Bank.
I addressed Asian economies and their potential reactions to a slowdown in the US three months ago (see SRI, 27 September 2006, Recession Fears):
If the US falls into a recession next year (while this isn’t my forecast, it’s a strong possibility), economies around the world will be negatively affected. The dominant view among knowledgeable observers is that Asia will suffer the most.
But it won’t hurt as much as is commonly believed. I offer no vote of confidence–yet–to those who state that Asian economies have decoupled from the US. But Asian nations are better prepared than ever before to deal successfully with a US economic slowdown.
My view remains basically unchanged. The test will be more difficult for the region’s financial markets. Foreign money can dry up quite fast (as we saw during last year’s May/June selloff), and at the same time, local investors could prove unwilling to step up and buy. Taiwan was one market local investors avoided in 2006.
Investing
The long-term Asia story (as outlined in The Silk Road to Riches: How You Can Profit by Investing in Asia’s Newfound Prosperity, a book I co-authored with my colleagues Elliott Gue and Ivan Martchev) is still intact. Far-sighted investors should have serious exposure–to the tune of 30 percent to 50 percent–to the region, including Japan, depending on your individual risk characteristics and investment horizon. This allocation recommendation assumes a well-diversified portfolio, the purpose of which is to reduce overall volatility as some assets appreciate while others depreciate.
The Portfolio has been constructed around the view that domestic economic demand and investment are driving Asia’s economic ascent. The areas I’m looking at for investment ideas continue to be property, infrastructure, financials, retail, telecom and utilities.
Infrastructure is an extremely important aspect of the investment strategy, one I’ll detail in a coming issue. Infrastructure-related companies in the Portfolio include Cheung Kong, Keppel and Mitsubishi Heavy Industries.
Korea could be the surprise of 2007 in terms of economic and market performance. The market, the second-cheapest in Asia after Thailand, was a weak performer in 2006. And although exports are slowing, the economy seems to have more strength than previously imagined.
Given that most fund managers don’t want to own too much Korea, there’s potential for a re-evaluation if positive news emerges, because all the negative news should be priced in by now. I prefer to get Korean exposure through its banks; as a sector, they trade at a substantial discount to the rest of the region. Portfolio holding Shinhan Financial is my favorite bank in Korea.