Asia ex Japan Any Good in ‘Uncertain Times’?

A look at what’s ahead in these uncertain times.

Growth prospects of Asia, and particularly China, remain appealing with a majority of Asian countries expected to grow above global average. In addition, Asian stock markets should also benefit from a successful ‘reflation’ on three fronts:

(a) rising investor/consumer confidence; (b) demand growth, with returning pricing power, which should thrive domestic consumption; and (c) exports and intra-Asian trade. On valuation, Asian stocks at an estimated 2003E P/E of 10.3x are just above a nine-year low and far below its five year average of 28.5x. Going into 2003, we maintain our overweight position, as we believe the Asia ex Japan markets are attractive in a global equity portfolio, even in ‘uncertain times’.

Reflation — A Remedy for Asia (Too!)

With policy makers around the world maintaining that they would use unprecedented measures to ‘fight’ deflation, having learned from Japan’s depression throughout the 1990s, the focus of market participants could in the later part of this year likely switch from deflation and ‘double dip’ scenario to growth and a return of pricing power. As highlighted in the last strategy paper (see also Stock Market Key on Asia ex Japan, ‘A place to hide?’, dated 4 October 2002), the region’s deflation pressure originates mainly from China, which we believe will continue to persist as China will maintain its overcapacity and high production levels in state-owned enterprises to support employment levels. Nevertheless, we assume that Asian stock markets would benefit from a successful reflation on three fronts: (a) rising investor/consumer confidence; (b) demand growth; and (c) returning pricing power. Key beneficiaries would be the high-beta stock markets of Korea and Taiwan, driven by export growth, while Singapore’s stock market, albeit being short of many export components, would benefit given their economic dependence on exports, particularly electronics. However, the cure would not come without side effects. One more pronounced effect would potentially be USD depreciation versus main currencies like EURO and JPY. An appreciating JPY could well lead to appreciating Asian currencies versus USD, in particular SGD, while USD-pegged countries would benefit. Once again, Hong Kong and especially China exporters could gain. That said, local policy measures could on the one hand soften some of the side effects and on the other hand trigger an even more constructive growth environment throughout Asia.

Asia — Domestic Demand a Defensive Buffer

With the exception of Hong Kong and Singapore, consumer credit has fuelled a consumption boom across Asia in 2002. Heading into 2003, the ultimate and obvious question is if the consumption boom would continue even though we maintain a very cautious view versus US consumers. The answer is: yes. What has driven the consumption boom in 2002 growth remains valid for 2003: regional banking systems remain very liquid, and banks are still wary of lending to corporates across the region with the risk appetite being on the rise. In addition, historic consumption patterns suggest that there is no correlation between US and Asian consumers, ie the Asian consumption trend escaped unscathed from September 2001 woes. Taiwan’s consumer credit versus income per capita remains considerably below average, while Malaysia’s consumer cycle could accelerate on increased fiscal stimulus. Despite being in a virtual circle throughout 2002, Thailand’s domestic economy should continue to thrive on the back of improved corporate profitability and wages, driving further consumption and investment throughout this year, while Indonesia will need to digest the higher living costs from rising fuel and electricity prices before returning to a more positive environment. If labour markets improve, both Singapore and Hong Kong could see better growth in credit and consumption. However, sentiment in both markets largely depends on the export markets outlook and thus, would be more dependent on a global economic recovery. India and China should see domestic macroeconomic stability and trade liberalisation benefits (effective rates of domestic import protection) to translate into considerable growth in their domestic demand. Korea’s consumer-led recovery looks to be drawing to a close, but a soft landing scenario is likely as there is no investment overhang and the government’s measures to cool household credit growth and property prices seem to be working.

Five years of restructuring have led to reduced capital expenditures, improved balance sheets and lower debt-to-equity ratios for corporates and institutions; while Asian countries have been maintaining current account surpluses, robust capital inflows and healthy foreign currency reserve levels. While Asia remains vulnerable to an external slowdown, we believe that its economies have become more defensive.

‘Made in Asia’ — Outsourcing Only Just Started

We believe that outsourcing will remain a key source of growth in Asia. Faced with low demand growth and margin compression, more US and European companies will be forced to focus on efficient deployment of capital, improving supply discipline and further cost cutting. Low-cost manufacturers in Asia, China in particular, are the major beneficiaries from this global pricing pressure. Although global capacity utilisation decreased on the back of dismal end-demand, capacity utilisation of Asian manufacturers have already recovered. For example, Korea and Taiwan have seen their capacity utilisation and operating rates turning and reaching almost their long-term average levels. Investments have also started to revive. China alone saw a record USD52.7b in 2002 of foreign direct investment (‘FDI’) entering the market. Asian countries are all well geared towards export. With the only exception of Indonesia, Asian exports to the US account for over 20% of their total exports. In countries such as Malaysia and Singapore, exports even account for over 100% of their GDP. Though we acknowledge that Asian countries’ high export leverages are a double-edged sword, the expected positive growth in the US and Europe expected for the second half of 2003 will be conducive to an Asian economic recovery. Trade liberalisation in the region, including China’s WTO-mandated tariff reductions, should provide further stimulus to intra-Asian exports. At the equity level, we believe companies with global export exposure and increasing outsourcing orders are well positioned to deliver stronger earnings growth in 2003.

Valuations Remain Attractive

On valuation, Asian stocks at an estimated 2003 P/E of 10.3x are just above a nine-year low and a far cry from its five-year average of 28.5x. On a price-to-book value basis (P/BV), Asia is close to historic lows at 1.4x. While current valuation implies a 9.2% ROE, we believe that a long-term sustainable ROE of 11% is reasonable. In comparison, the US’s P/BV 2.2x is still implying a mid-term ROE of 25% compared to a more sustainable ROE of 10% and a historic ROE average of 14.8%. Although current low nominal yields dampen the overall nominal ROE, real ROE are expected to peak in 2003 given a combination of low capital expenditure to sales ratio (from 18% in 1995 to 11.5% expected this year), higher asset turnovers and expanding EBIT margins (ie divestments of non-core assets). Therefore, the Asia ex Japan market seems considerably undervalued on a relative and absolute basis. We maintain our overweight position in Asia ex Japan in a global equity portfolio.

Ivo Mathias Buschor and Desmond Tjiang
UBS Private Banking
For enquiries: econtactasia@ubs.com