Download Havenport-Asia Pacific Ex Japan Market Commentary_Jun 15

ASIA PACIFIC EX JAPAN
JAPAN EQUITIES MARKET COMMENTARY JUNE 2015
The performance of Asia equities so far this year has been a tale of two (hemispherical) halves. The
northern half of Asia delivered positive returns, while the southern and south east half did not. In
aggregate, the MSCI Asia ex Japan is up 7.8%*, but down 5.6%* from its recent peak as a result of
the usual mid-year market lull and liquidity vacuum. The positive outcome this year masks the
performance skew towards China in particular, without which Asian equities would have had a poor
year. The MSCI South East Asia for example is down 3.7%* this year and down 7.8%* from its recent
peak.
The sheer force of the margin-fuelled “A” share rally has served as a magnet, pulling Hong Kong and Hshares sharply higher. The divergence between the trajectory of the Chinese stock market, and the
sluggishness of its economy is glaring, but this is widely understood. Most economic indicators suggest
the Chinese economy remains in flat line mode. How one views the rally is entirely a function of
perspective. In essence, it is a bull market if you own it and a bubble if you don’t. The reality is however
somewhere in between. The valuation of the Shanghai Composite Index appears a troubling 3 standard
deviation above its 5 year mean PE^, but is at a less frightful, 1 standard deviation above mean when
viewed from a 10 year perspective. This is a result of the massive and prolonged de-rating that had
occurred after 2007. By comparison, the valuation of the MSCI Asia ex Japan Index is trending below
mean over the same 10 year period. Although the MSCI has elected not to include “A’’ shares in its
emerging market indices this time around, it is probable that its (very sizeable) inclusion could come
about in the next 12-18 months. This, together with the inevitable internationalization of the Renminbi,
the launch of the Shenzhen-Hong Kong Connect, and the widening of the Shanghai-Hong Kong
connect, means the rally has ways to go even if the volatility feels discomforting. We are content to be
followers in this government sanctioned rally, but are expressing our higher conviction elsewhere in
Asia. Taiwan and Korea have also been pulled up by China to some extent, although there are
idiosyncratic drivers particularly in Korea that contributed to its outperformance so far this year. MERS is
now exerting downside risks to growth in Korea, to which the Bank of Korea has promptly responded
with a cut in its repo rate. The KOSPI index has only fallen in line with the MSCI Asia ex-Japan index
since the outbreak of MERS, suggesting no panic. We similarly do not see reason for concern per se.
Taiwan, together with Singapore are the odd-man out, being the only two markets that have suffered
valuation de-rating in Asia through the course of the year. This notwithstanding, Taiwan has produced a
positive return while Singapore has not#. Taiwan financials contributed to the market’s performance this
year, owing to speculation that a Shanghai-Taipei connect might be in the offing. In reality, investors
needed a reason to rotate from technology shares to financials, which had suffered from depressed
valuation and neglect. Financials needed an excuse to play catch up to its tech peers.
The picture in the south is dismal. As highlighted earlier, the MSCI South East Asian Index is down
3.7%* this year, and down 7.8%* from its recent peak. Performance drivers are either lacking (in
Singapore’s case), or negative (in Indonesia or India’s case). The Singapore market has largely been
overlooked, as investors focused on chasing performance in the North, while mitigating
underperformance in the South. Singapore’s underperformance is a result of investors neglect; like
Taiwan, the Singapore market is trading at more than 1 standard deviation below its 5 year mean
*Factset, 24 June 2015, USD terms
^Bloomberg, 24 June 2015
#Factset, 24 June 2015, USD terms, price return
PER^, in-spite of a consistently upward trending earnings profile. Like Taiwan financials, the Singapore
market needs an excuse to rally, but none is immediately obvious. Within the context of an undervalued
market, Singapore small caps have remained deeply depressed. This is a combination of a lack of
confidence and an excess of neglect. Some of the best value buys in Asia can now be found in
Singapore small caps in our view. We have hung onto our Energy Services theme, and believe the
worst is behind us. Confidence remains fragile and recovery is nascent. While the nearer term direction
for crude prices remains a subject of speculation, it is exhibiting far less volatility than 6 months ago.
Contract negotiations and pricing terms are difficult to conclude when volatility is heightened, so a more
stable crude pricing environment is the beginning of some return to normalcy for the energy services
space. Investors will soon begin to look to 2016. The earnings downgrades for 2015 creates a more
favorable base effect, and this will eventually make it difficult to ignore the valuation in this sector, and
it's secular growth potential even at USD 60-70 oil.
With regards to Indonesia, the lustre of a brand new presidency and all the potential that comes with
Jokowi has worn off. The populist stance taken by the politicians in turn is concerning, and not helping
an economy in need of an impetus. Vice President Jusof Kalla’s latest remarks that state-owned banks
will halve lending rates to small businesses, and Jokowi’s instruction to cut road tolls by 25-35% during
the upcoming Ramadan season reeks of moral hazard and populist tendencies(source: Jakarta Post).
This is a huge let down to investors who had expected much from the very successful and popular,
former governor of Jakarta. We have been very underweight in Indonesia for a long time, but are now
observing that valuation of this market is reverting to long term average from having been significantly
overvalued. Even so, the catalysts for the market to return to its outperforming ways are not yet present.
Unlike Indonesia, the fundamental outlook for India remains highly compelling. India is correcting from
its massive bull run last year, and while the government is executing well, its effort is not yet translating
to real growth improvement. The RBI is meanwhile highlighting inflation risks, citing delayed monsoons
as a major factor, and becoming more circumspect about further rate cuts. We think this is as much
posturing as it is real inflation concerns. Perhaps this will compel the government to move even quicker
to spur growth. India remains a bottom-up story, and we are looking at opportunities to increase our
exposure even as investors are cutting back.
When we entered 2015, the dominant concern was the strength of the US dollar, and its impact on
Asia. The explosive rally in China mitigated the negative impact of the strong USD on Asian equities.
China's performance lifted regional indices although in truth, few portfolio managers can claim
analytical advantage; investment views regarding China largely pivots on how far one feels the
government will allow the rally to run before its rescinds its tacit approval of the runaway 'A' train. Rate
cuts are succumbing to the law of diminishing returns. The DXY Index has rolled over since its peak in
March, but so have Asian markets. This is due to investors’ concerns shifting to rising bond yields, and
due to the prospect of a Fed hike. The unfolding Greek drama is annoying at the margin, although the
consequence of a Grexit today is unlikely to have the same impact had this happened a few years ago.
In all, the selloff in recent weeks is a controlled reaction to series of negatives occurring during a
seasonal lull, reflecting investors’ confidence that Europe will be better to cope with Greece, and with
the confidence that the first Fed rate hike will not derail markets.
^Bloomberg, 24 June 2015
As we enter into the seasonally challenging Q3, we expect volatility to remain high but Asian markets to
be broadly directionless. Retail Chinese investors are learning stocks can fall as well as rise. The rest of
the Asian markets will take its cue from China, and from the Fed action. On the other hand, European
quantitative easing will keep markets aloft. Meanwhile, Asian valuation remain compelling, with the
MSCI Asia ex Japan Index trading at 1 standard deviation^ below its long term mean relative to MSCI
World. The net effect is a wash, and the conditions are unconducive for a stronger expression of
conviction in our portfolios just yet.
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