It’s been a tough start to the year for Asian stock markets — regardless of the disaster-driven tumult in Japan — with the trends that drove many of them higher last year turning against them.
The massive investment inflows that buoyed emerging markets in the second half of 2010 changed direction in the first three months of 2011, as geopolitical risks surged, on top of higher oil prices and the threat of inflation.
Those concerns have encouraged investors to pull money from both emerging markets stocks and bonds, and shift it into developed stocks.
Strategists believe the second half of this year may be the time to give Asia ex-Japan another look.
Michael Kurtz, head of strategy for Asia ex-Japan at Macquarie Securities, says there’s a case to be made that emerging markets stocks are now cheap compared with U.S. equities.
“Asian markets have probably been sold unjustly on expectations that we would see an extended dollar rally,” says Kurtz.
But with the U.S. Federal Reserve not leading the tightening charge this time around, or even participating, “Asian currencies have continued to hold up quite nicely against the dollar. Therefore the foreign-exchange argument for getting out of emerging markets is not justified in this process.”
Fund flows may shift later this year, something that has severely hurt Asian stocks, and benefited developed markets, so far in 2011.
In February, for instance, investors pulled $7.6 billion out of emerging-markets equities and $1.1 billion out of emerging markets bonds, according to Société Générale. That’s in sharp contrast to the $28.9 billion of inflows into emerging stocks since last September, a huge cash injection that boosted the amount invested in those markets by 8 percent to $458 billion.
Fund flows have been the most important factor in the poor performance of Asian equities this year, strategists say. The MSCI Pacific ex-Japan index was down 5.5 percent year to date, through late March, while the G7 index — even factoring in the “Japan effect” — was up 0.8 percent.
The fund flows situation “has been a challenge for larger, more liquid Asian markets simply because they are easier to sell,” says Kurtz. “They have been punished simply by being not in the right asset class.”
Still, Kurtz believes the flows are a short-term trend that’s about to end.
“We are taking the view that the emerging-to-developed flows story is tactical and is one that’s more likely to abate by the middle of the year,” he said.
Garry Evans, HSBC’s chief strategist, admits it has been an “odd” start to the year, and not the kind to be overweight emerging markets.
He also attributes their poor performance to fund flows, and believes it is a result of investors in the West rediscovering an appetite for risk. They have taken money out of bond funds, and moved it into stocks in the most-established markets.
He expects investors to slowly take on more risk, shifting to less-conservative investments. “We remain comfortable with the view that EM [emerging markets] will outperform DM [developed markets] during 2011,” Evans noted in his latest equity-strategy outlook.
HSBC feels that it is too early to buy back into India and China, until their inflation fears subside, although that may happen later this year. It has a neutral weighting on China, and a big underweighting of India, as a result.
“We could expect the clear peaking of inflation in China and India, in particular, to be a signal for a strong rally in stocks,” Evans said in his forecast. “We do not expect this to happen until the summer – but investors need to watch carefully for the right timing to re-enter these markets.”
Until that occurs, Evans prefers second-tier emerging markets instead, with Russia, South Africa, Korea, Taiwan and Malaysia as its top picks.
Kurtz also identified Korea and Taiwan as his favorite Asian markets coming into the year. But higher oil has been a headwind for both nations, and coupled with the fund flows has caused poor performance. The challenge now “is to decide whether we want to double down on those markets,” he says.
Taiwan was down 8 percent through late March, and the Philippines was off 11 percent, with India the worst performer in Asia, down 14 percent. Not one Asian emerging market was in the black, a sharp turnaround from last year when Thailand, Malaysia, Korea and Indonesia posted some of the world’s biggest gains.
Several of those frontier markets likely offer the best long-term prospects for economic growth, a recent Citigroup report argues, with developing Asia and Africa set to be the fastest-growing regions, driven by population and income growth.
Banking On 3G Countries
Citigroup chief economists Willem Buiter and Ebrahim Rahbari have identified what they call the “3G” countries, or Global Growth Generators, that they believe will deliver some of the highest growth and most profitable investment opportunities over the next five to 40 years.
The 3G nations take the concept of emerging markets or the BRIC nations — Brazil, Russia, India and China, a concept fostered by Goldman Sachs Asset Management chairman Jim O’Neill in 2001 — a step further.
“The expression ‘emerging markets’ is clearly past its sell-by date,” Buiter and Rahbari write, too large and vague a term to be useful.
They instead identify the 11 3G countries — Bangladesh, China, Egypt, India, Indonesia, Iraq, Mongolia, Nigeria, the Philippines, Sri Lanka and Vietnam — which have the most promising growth prospects between now and 2050.
“All of these countries are poor today and have decades of catch-up growth to look forward to,” the report states.
There will be substantial changes in that period. Citi forecasts that China will overtake the United States as the world’s largest economy by 2020, and will in turn be overtaken by India by 2050.
“Growth will be bumpy. There will be busts as well as booms. Beware of any proclamations of an end of volatility. Poor policies, conflict and natural disasters will change the growth equation for some countries in a negative way,” according to Buiter and Rahbari. “But there is little doubt in our minds that the prospects for broad, sustained growth in per capita incomes across the world have not been as favorable as they are today for a long time, possibly in human history.”
Kurtz at Macquarie agrees that countries such as Vietnam, Indonesia and Bangladesh stand to gain from China’s development as an economic powerhouse.
“We have been making the case that fundamentally China’s restructuring creates new opportunities for the more demographically endowed South and Southeast Asian economies to move up the curve, and capture some of the space that China is deliberately vacating,” says Kurtz.
But meshing such long-term trends with short-term market movements is difficult. With Indonesia’s strong gains last year, those long-term trends were clearly priced in, and the vast majority of managers were overweight.
“There wasn’t any more room for the market to go up,” says Kurtz.