JANUARY 2010

Asian markets were generally weaker in January, spooked by China's aggressive tightening stance as well as fiscal problems in Greece.  Notably, the H-shares listed in Hong Kong as well as Hong Kong’s Hang Seng Index declined by 10.1% and 8.1%, in US$ terms, respectively.  Only the Indonesia’s Composite Index rose by 3.6% during the month of January. KLCI started the year, scaling new highs and broke through the 1,300-point psychological barrier. It, however, ended the month at 1259.16 points, down 1.1%. That said, KLCI managed to outperform the MSCI Asia ex-Japan, which has fallen 6.1%. While Asian equities have fallen by an average of around 5%, KLCI was the second best performer in the region given its low beta nature.

Last month, we made the observation that, relative to past economic and stock market recoveries, Asian equities in January 2010 were not at frothy levels yet, hence implying that the ten-month old bull run had still room to continue.  The fiscal problems of Greece, however, has become the trigger to a market consolidation that may take Asian markets to their June 2009 levels—implying a potential 5% - 13% drop from market levels at end-January 2010.  Hence, while Asian markets may not have run up to frothy levels, they have run up to levels where they have become susceptible to bouts of negative corporate or economic surprises.

Fundamentally, the fiscal problems of Greece have reminded us that excessive debt levels are spread across a number of countries and that high debt levels are not just a problem in the US.  Granted, not all countries have a problem with high debt levels concentrated within the Household sector, as in the US.  In Greece’s case, the high debt levels are concentrated at the Government sector level.  In a study of 14 countries (10 developed economies plus Brazil, Russia, India and China), McKinsey Global Institute also identified other countries like Spain and the UK as having high debt levels in the Corporate sector (which includes the commercial real estate sub-sector) and their Financial sector. 

In Greece, government debt/GDP as at end 2008 was about 100%, way above the 60% threshold set under the European Union (EU)’s Stability and Growth Pact (SGP) for new entrants into and members of the European Union.  Within the EU, only Italy has a higher debt/GDP ratio.  Greece’s deficit/GDP ratio has also been revealed to be an estimated 12.7%, compared to earlier targets of 6% - 7% versus an allowable 3% under the SGP.  The longer Europe delays in dealing with Greece, the higher the chances of contagion to other European countries.  In the meantime, contagion from Greece may well impact the UK which remains particularly vulnerable given its high total debt/GDP levels of over 450% (as at 2Q 2009)—much more highly leveraged than the US economy.   

The significance of the above problems is that it will all lead to the unwinding of the US$ as a funding currency for Asian assets—for both the equities and fixed income markets.  The problems of excessive leverage and the slow pace of debt reforms in Europe mean that the Euro is not shaping up to be a strong alternative reserve currency to the US Dollar.  The strengthening dollar against the Euro will lead to the unwinding of the US$ as a funding currency. 

The blow up of Greece’s public finances could not have come at a worst time to shake up confidence for Asian equity markets.  The problems in Europe coincide with the efforts of Asian policy makers to rein in rising asset prices via a tightening of credit and monetary policy—providing a good sell trigger for the markets.  

Following the recent correction of Asian equity markets, valuation has also reverted to levels of 1.8x, which near their average trailing PB ratio of 1.7x—an indication that markets are not overvalued.  Forward PERs do not look stretched given that it has come down to mean levels of 13.5x but these multiples may be understated given the strong projected earnings of about 31% in 2010.  Nonetheless, valuations, from a top down perspective, are not excessive.

The weak sentiment in Asian markets should also be balanced somewhat by a broadening recovery in the US.  The Case Shiller Index, an index of house prices, has risen for the last 6 consecutive months.  Unemployment is not shooting sharply higher but has surprised with the latest figure of 9.7% and is down from 10.0% in the previous month.  Fourth quarter GDP for the US was 5.7%, stronger than the estimated 4.5%.

As mentioned in earlier reports, the year 2010 will be a year for stock picking.  We have been lowering our equities exposure in recent weeks and would seek to opportunistically use the cash raised to reinvest in stocks that have declined to attractive levels.  Countries that continue to offer relative value from a top down perspective include Korea, Thailand and China’s H-shares while we will continue to seek for value stocks in sectors that include early cyclicals like commodities, technology and financials for the play in economic recovery, oil & gas for the exposure to rising spending in this sector, infrastructure and building materials that benefit from the fiscal stimulus programmes of the various countries.