Risks and rewards for 2010

Already, some strong signals and statements have swayed the markets with January hardly over: especially US President Barack Obama’s unexpected attack on alternative investment by US banks, coming concurrently with the PRC’s announcement that its GDP grew 10.7% in the last quarter of 2009, according to the National Bureau of Statistics. Commentators and lobbyists alike already appear to have both alternative investments and emerging markets high on their agendas as the 21st century’s second decade begins. With the Asian Financial Forum in Hong Kong just concluded, and the annual meeting of the World Economic Forum about to begin in Davos, we look at the policy-level picture as it affects investment opportunities, and macro risks, in the year ahead.

The emerging markets growth story

The big policy challenge for 2010, almost all commentators agree, is to time and manage the withdrawal of Western and Asian governments’ unprecedented stimulus packages, balancing the risks of excessive deficits and long-term economic damage on the one hand with those of pushing the global economy back into recession on the other.

“Most observers anticipate a modest recovery,” confirmed Dr Gerald Corrigan, a managing director at Goldman Sachs and former president of the Federal Reserve Bank of New York. However, this brings its own problems. “Now there is a real recovery, the question is when do you exit?” asked Professor Nouritrueel Roubini, Professor of Economics at the Stern School of Business in NYU. “If you exit too soon, take away the fiscal and monetary stimulus, and demand has not recovered, you might go back to a recession and deflation.”

Few in Asia at least fear any near-term recession. Emerging markets, as is widely recognized, have come very well out of the crisis, and appear set to lead global hopes and expectations – if not actual growth – out of the recession. “We remain very optimistic about growth across Asia Pacific,” is one typical view, from Frederic Neumann, Senior Asian Economist at HSBC.

“There’s ample evidence that the global economic downturn has not been as severe here in Asia, and that the region is recovering much faster than the US and European economies,” noted Michael Smith, CEO, ANZ Banking Group. Garry Evans, Global Head of Equity Strategy at HSBC, likewise averred, ‘it’s going to be a very good year for Asian growth.” And Andrew Legge, Director at Dragon Capital, confirmed hopes for the new year already rising at the end of 2009. “There was a lot of excitement from people saying, I’m tired of being in the doldrums.”

International investors are responding accordingly. “In recent years, we have shifted our focus from developed economies to these emerging markets,” said Lou Jiwei, Chairman and CEO of the China Investment Corporation. “They are the major stabilizer in the global crisis. We have seen very strong growth in these emerging markets. In the past ten years, they took up global GDP by 23%.”

In contrast, Western markets, particularly the US, look likely to remain hampered for the present. “Even though the darkest days of the crisis occurred more than a year ago, the legacy of the crisis, in terms of swollen central bank balance sheets, large governmental capital interventions in financial and non-financial institutions, and virtually unprecedented budget deficits in the US and elsewhere, is still with us,” said Corrigan. “Winding down these extraordinary but necessary interventions will not be easy, especially in the case of the US budgetary deficit.”

Emerging consumption, emerging dominance?

As already noted, much hope and positive sentiment is now riding on the Asian emerging markets story. Investors seem to have little reason to fear that their hopes will be disappointed; but the more important question is what Asia’s continuing growth can accomplish, and for who.

Fortunately, given the falloff in Western demand, most observers concur that Asia Pacific consumption was already on track to speed up growth independently. “There’s evidence now that the Asian economies have decoupled their economies from the West,” Neumann observed. “One of the prime indicators of decoupling is very strong consumption.”

Partly this was a timing issue: many Asian economies, and particularly China, went into 2008 already in a cyclical recovery phase. Consequently, most had already started their rebound from the bottom of their own relatively modest slowdown when the worst of the financial crisis hit with the collapse of Lehman Brothers in November 2008. As Neumann affirmed, “The reason Asian policy-makers needed to stimulate growth so aggressively was that domestic consumption was already in a recession before the crisis hit us.”

Since that acute phase of the crisis did not directly involve any inherent systemic breakdowns in their own markets comparable to, for instance, the sub-prime debacle in the US, Asian economies could continue to ride the momentum of their own recovery out of the global slump in 2008-09. “Most of these emerging markets did not have the kind of leverage in the financial system and housing sector that became problems in the US and other advanced economies,” Roubini pointed out.

However, the global macro environment still needs readjusting, no matter how strong the domestic consumption growth in Asia – at least according to Roubini. “For the last decade, the US and Western countries were the consumers of last resort, spending more than they saved,  running current account deficits; while China, Asia, Japan, Germany, emerging Asia, Latin America, were the producers of last resort, spending less than their income, running current account surpluses. Now the overspending camp is consuming less, importing less, and reducing their trade deficits.”

The consequence is that Asia Pacific’s macro recovery is likely to keep its benefits at home, rather than providing any impetus to pull developed economies out of their self-inflicted slump. “Such growth cannot offset the shrinkage we have seen elsewhere,” cautioned Lou. Roubini also took the view that, “China can help itself, can help emerging Asia, can help commodity exporters, but it cannot be the only engine of global economic growth.”

This is not everyone’s view on China. “China has come first out of the recession and it is once again likely to be the engine of economic growth,” asserted Alderman Sir David Brewer, Chairman of the China-Britain Business Council and former Lord Mayor of the City of London. However, most market participants follow the thesis, articulated by Neumann, that: “the US consumer is much more important in the overall scheme. US consumption is $10 trillion per year. Asian household spending is $4 trillion.” And Roubini also affirmed that: “Chinese GDP is only $4 trillion; US GDP is $10 trillion …
The total consumption of 2.2 billion Chindians at $1.6 trillion is one sixth that of the US.”

That relatively low level of consumption limits, for the time being, the demands that cane be made on it. “Many emerging markets will need to shift from dependence on foreign markets to putting more focus on domestic demand. This is going to be the major theme for the time to come,” concluded Lou. Neumann pointed out that “Asian consumption is growing so fast that we are compensating for the reduction in the West,” but this compensation is for domestic purposes only, more or less sustaining growth rates in the region. Western economies hoping for a share of it may be disappointed, and Western investors will need to take on board the consequent risks and choose their forms of exposure with care.

Market risks

Even when investors and others fully accept Asia Pacific’s strong and durable macro prospects, many doubt that the next year or two will see an easy and worry-free recovery.
In particular, Smith went on, “Although there’s been a very strong recovery in asset markets over the past 12 months, that recovery has been much less apparent in real economic activity, which remains quite subdued at best.”

The kind of overheated investing and yield-chasing that engendered much of the instability in the financial system in 2006-07 does not seem to have gone away, unfortunately. Roubini pointed out that one of the biggest out of several sustained rallies across various asset classes during 2009 was: “in emerging markets asset classes: their stocks, their bonds, the strengthening of their currencies.” And he asked, “How much of this rally is due to the actual fundamentals? … Is it too much, too fast, too soon, driven by factors like a wall of liquidity chasing assets?”

This feverish pursuit of yield could run into a number of roadblocks. One specific risk is protectionism, which remains a danger amid the populist rhetoric popular post the crisis. “To return to protectionism and trade barriers, in a mistaken belief that this will protect domestic jobs, is misguided,” Brewer pointed out. “We are emerging from one of the most difficult periods in recent history, but globalization has not been its cause. Open markets will ensure that markets recover sooner.” Lou also felt that: “Things are gradually improving, but in some places people are already thinking trade protectionism.”

Furthermore, many market players and observers question the substitution principle of boosting domestic demand to compensate for lower consumer appetites overseas. “I feel good about an economy where it’s already known to be strong from a domestic perspective,” remarked Legge. “I feel skeptical about countries filling the void from a consumption perspective.”

The most severe risk Asia Pacific as a whole runs, though, is to be a victim of its own success and allow growth to overheat, with already-present inflation building to dangerous levels, and the requisite tightening and correction becoming fiercer and sharper the longer it is delayed. “We will see further appreciation of asset prices across the region,” cautioned David Bloom, Global Head of Foreign Exchange Strategy at HSBC. In his view, part of the problem is that most Asian central banks are still shadowing US interest rates, even though their own situations require very different actions. “This is a policy challenge for Asia. Growth has decoupled, but we need to decouple monetary policy.”

Also on the political side is the risk of unexpected policy turns, which simply reflects the greater influence that politicians worldwide are having on markets, now that the hands-off tactics of the previous decade have been comprehensively abandoned. “We haven’t seen the details of what Obama’s suggesting, but it keeps coming as a shock,” said Bloom, highlighting just one example. “What politicians say and do is mattering.”

Asia’s individual markets

Prospects for the investors in the individual markets in Asia Pacific overall appear good, as far as there can be any consistency across such a broad, diverse and highly fragmented region. The one exception, as so often, appears to be Japan, which seems destined to trade like a mature, structurally flawed and more or less stagnant European economy. “The potential growth rate in the Eurozone and Japan is 2%, maybe lower,” observed Roubini. “An acceleration of growth in the Eurozone and Japan requires an acceleration of structural reforms.”

In contrast, the region’s other major developed economy, Australia, appears likely to move with the Asian bloc more than ever, partly thanks to its linkage to China and the Asian growth stories through its considerable tilt towards mining, resources and commodities. Indeed, so powerful is China’s influence becoming on the Australian market that: “the Australian dollar trades much more like a synthetic RMB; it trades with the Chinese market,” as Bloom pointed out.

China itself, of course, continues to offer an attractive growth horizon across many investment theses. “Investment opportunities are extending throughout the country. The China market is not just concentrated in Beijing, Shanghai, Guangzhou, or even on the eastern seaboard,” said Brewer, also pointing to “the evolution of the services sector of the Chinese economy, which is estimated by some observers to account for almost two thirds of the economy by the middle of this century. With the development of these services comes a requirement of capital and expertise.”

Domestic consumption in other markets which were initially less exposed to export demand offers robust opportunities that are fairly resistant to the problems in the West.
“In India and Vietnam, where it’s better understood that domestic consumption is part of the economy already, I feel a bit better about the prospects,” said Legge, while adding “I don’t want to come off as at all negative” on expectations for other markets in the region.

Some views on India are cautious, though. “The market I would be very nervous about now is India,” warned Evans. “India has a much worse inflation problem than China; it’s very expensive … India is one of the most overpriced markets in Asia: arguably one of the most over-loved markets by foreign investors.”

For Vietnam itself, meanwhile, “our beliefs about what will happen for Vietnam for the next five years are positive,” in Legge’s view. “The government is very active in managing this economy; we feel that 2010 will create a very compelling case for deploying capital.”

The strength and breadth of Asian domestic growth can be seen even in currently unfashionable markets like Taiwan, which appeared to be among the biggest casualties of the collapse in Western demand. “Taiwan, which has always been so export-dependent has seen a very strong bounceback in domestic demand,” Neumann pointed out.

However, investment in the still-turbid environment of 2010 remains a challenge, even for the best-advised and best-funded. “If I look at the market situation and try to make projections, and then allocate money, it’s very difficult to make correct predictions,” concluded Lou. “Sometimes we cannot invest the capital we have.”

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