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Asia’s Economic and Financial Market Landscape - 2004 In retrospect, 2003 “We see little out there – economically at least – that makes us want to turned out to be quite change our strategic long Asian equity and short dollar/Asia currency an easy year from a biases, and stand ready to pile back in as and when it becomes clearer that macro trading the world is not collapsing around us. While the time is not now, our target perspective thwould be some time around Q2.” DSGAsia January 6 2003. SARS provided the In retrospect, 2003 turned out to be quite an easy year from a macro trading classic bottom of the perspective. As we suggested above twelve months ago in our year opener, market cathartic purge the main call to make was to gauge when to ditch the long rates/deflation required trade, and jump back into the equity quagmire. And fortunately, SARS provided the classic bottom of the market cathartic purge required. DSGAsia Notional Portfolio Versus MSCI Indices160 160January 2002 = 100150 150Annualised Portfolio Return: 22.7% DSGAsia Notional PortfolioAnnualised Portfolio StDev: 8.6%140 140Sharpe Ratio: 2.7130 130120 120MSCI Asia-Pacific Free110 1103M US T-Bill100 10090 90MSCI Asia-Pacific Free ex Japan80 8002 F M A M J J A S O N D 03 F M A M J J A S O N D What to do in 2004? As the chart above illustrates, our trading recommendations have performed pretty well in both absolute and relative terms over the two years we have 1been ...
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Asia s Economic and Financial Market Landscape - 2004
We see little out there economically at least that makes us want to In retrospect, 2003 change our strategic long Asian equity and short dollar/Asia currency turned out to be quite biases, and stand ready to pile back in as and when it becomes clearer that amna ceraos tyr ayedianr gf rom a the world is not collapsing around us. While the time is not now, our target perspective would be some time around Q2. DSG Asia January 6 th 2003. In retrospect, 2003 turned out to be quite an easy year from a macro trading SARS provided the perspective. As we suggested above twelve months ago in our year opener, classic bottom of the market cathartic purge the main call to make was to gauge when to ditch the long rates/deflation required trade, and jump back into the equity quagmire. And fortunately, SARS provided the classic bottom of the market cathartic purge required.
DSG Asia Notional Portfolio Versus MSCI Indices 160 January 2002 = 100 150 nnualised Portfolio Return: 22.7% 140 nnuali sReadti oP:o 2rt.f7olio StDev: 8.6% Sharpe 130
120 110 100
MSCI Asia-Pacific Free
DSG Asia Notional Portfolio
3M US T-Bill
160 150 140 130
120 110 100
90 90 MSCI Asia-Pacific Free ex Japan 80 80 02 F M A M J J A S O N D 03 F M A M J J A S O N D As the chart above illustrates, our trading recommendations have performed What to do in 2004? pretty well in both absolute and relative terms over the two years we have been running our notional portfolio. 1 FX and rates trades have allowed us to make money in down equity market periods but we have also captured most of the upside in stocks while taking on limited equity exposure. Selective country tilts with an Australasian currency overlay have paid off large. However, that was then and this is now, so what to do in 2004? 1 The returns are unaudited so you will have to take our word for it. However, if you have tidily filed away all of our Trade Winds pieces, you can check to see whether we are telling porkies or not.
DSG Asia 5 January, 2004
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Asia s Economic and Financial Market Landscape - 2004 Summary of Views: January 2004 Regional Views Strategic Biases Trading Tilts Equities Lon Lon Rates Flat/Short Flat/Lon Forex Lon Lon Country Views Strategic Biases Trading Tilts Equities Rates Forex Equities Rates Forex Japan Long/Short Flat Long Long TOPIX 2nd --a - - Lon -- Kore - Taiwan - - --- - Hon Kon Lon Short - Lon - - China - - - - -- Sin apore - ---SGD/USD 10 - Mala sia Lon - --- - Thailand - - Lon -- - Indonesia - - - - - - Philippines - - - - - - India Long - - Long - - Australia Lon - - Lon UD/KRW - - New Zealand - - Long - - Long NZD/KRW Global/Re ional Drivers Near term global strength but unsustainable much beyond H2. China and the US to slow No imminent Asia/USD realignment. Risk of accelerated dollar decline later in the year Asian earnings to outstrip GDP growth; overseas money to follow and domestic risk appetites to improve Lots of regional political wild cards. An opportunistic trading and market timing focus required Sectoral Themes Sceptical tech but long tech commodities versus infrastructure Long local financials/brokers versus international financials Overweight consumption, resources, energy extraction & exploration until China rolls that is Small/mid-caps bias but near term, large caps to do well on back of international fund flows Notes: Views in Red = Strong Conviction ; Views in Bold = Change of View Trading tilts 1-week to 3-months; " - " implies no strong view expressed currently Equity views do not incorporate tilts against index weightings, trading tilts express strong relative preferences Rates views are sovereign/money market based; Forex views against the USD unless otherwise stated DSG Asia 5 January, 2004 2
Asia s Economic and Financial Market Landscape - 2004
Unfortunately we think 2004 is going to be a whole lot harder, 2 and while it seems an age away, 2005 could shape up to be a complete horror story. For this year, the two major macro calls will be to assess when the steroids coursing through the veins of the US economy begin to wear off, and when and if Chinas attempts to moderate fixed investment excesses start to gain traction. Our own biases are skewed towards the end of the year and we are looking for the two occur at roughly the same time, hence our 2005 fears. But we suspect that sentiment could oscillate wildly before then and one should therefore expect to see increased market volatility. Much as we prefer to pick three or four good macro stories each year and just let them ride, we do not think such luxuries will be afforded in 2004. A highly opportunistic and market timing focus will most likely be required. Every year at this time, we reproduce the first chart over to indicate how previous money creation impacts on real activity. The dysfunctionality of money multipliers currently remains clear to see. Unprecedented rates of liquidity creation compared to the norms of the past twenty years have failed to stimulate much more than a blip up in OECD industrial output and the sustainability of these gains seem somewhat questionable. The aggregate disguises variations between countries US real GDP performance has been notably stronger than its IP growth in recent times and also does not include the rapid growth seen in China. These have both served to boost the global GDP performance but also the disparity highlights just how insipid output and demand have been elsewhere. Moreover, the money numbers in the US have already decelerated alarmingly in recent months while Chinas broad money growth is also starting to roll. We have little confidence that if one or both of these drivers starts to falter, other areas will be able to take up the strain.
2 It could also become quite a bit harder for DSG Asia from a business perspective. The regulators in America, like their UK counterparts earlier, are flirting with making it harder for independent research companies to operate. Specifically, there is a proposal to only allow independents associated with major Wall Street firms to be paid via trade executions. Quite how a research boutique retained by a bulge bracket firm can be considered independent is beyond us but then again, the whole approach of the regulators has seemed akin to using a carpenter to fix a leaky tap. No wonder so few decent analysts are prepared to take the risk of the entrepreneurial route.
DSG Asia 5 January, 2004
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2004 is going to be a whole lot harder and while it seems an age away, 2005 could shape up to be a complete horror story
The dysfunctionality of money multipliers currently remains
Asia s Economic and Financial Market Landscape - 2004
Excess Broad Money Leads Economic Activity 14% 14% 12% *M Doenveiya tiGorno fwrtohm v terresnuds oOf EPCroDx yN oOmEiCnaDl GDP 12% 10% 10% 8% 8% S&L Clean-up, Dysfunctional US OECD Industrial 6% grfionwatnh,c iaGlr esyats tfeorm :A sBiaadn faosr sUetSs !!! Production (LHS) 6% 4% 4% 2% 2% 0% 0% -2% -2% -4% -4% -6% OECD Excess Broad Money* -6% Brought Forward 18 months (RHS) -8% -8% 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
20%
10%
Asian Exports and OECD Industrial Production 40% 8% USD %YoY, 3MMA %YoY, 3MMA 6% 30% 4% 2% 0% OECD Industrial Production (RHS) -2% -4% Asian Exports (LHS) -6% 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
0% -10% -20%
DSG Asia 5 January, 2004 4
Asia s Economic and Financial Market Landscape - 2004
Nevertheless, we see growth momentum in both America and China continuing to be firm for the next few quarters and underpinning the recent upturn in global exports (see the second chart above). Asia, with its hypercompetitive currencies, should be the major beneficiary and improving external sectors should also spill over into firmer domestic demand. It is even possible to a make a similar argument for euroland albeit monetary conditions are by no means as loose Why our near term optimism on the two big Kahunas? In the case of the US, another round of personal income tax rebates in the spring, and the 50% bonus depreciation allowance for corporate investment through to January 1 st 2005, should maintain growth in the 3-4% range during H1. Our near term concern, therefore, is that bond yields are set to back up steeply although, in mitigation, this seems to be a pretty common view. We discussed this issue in detail in our December Trade Winds but in short, if yields grind upward in an orderly manner, then equity markets should remain well bid. They would view the alternative of a 1994-style sell-off far less benignly. Beyond H1, we have major growth sustainability concerns and with the Funds rate at 1% (we are not expecting the Fed to tighten any time soon), and budget and current account deficits in the 6% range, one has to question what ammo will be left if things slow again. Really, really trash the dollar would seem the answer and perhaps rig the bond market to boot. We will flesh out our views on the possibility of a de facto US debt default in a forthcoming article. But the logical conclusion is that we retain our lust for gold and, although it is not our area of expertise, we would look to buy euro denominated bonds as and when growth expectations start to wane again. Hang on a minute you old curmudgeons we hear you say. After all, it would seem that we do not realise that there are 1.3 billion people in China, and that they are going to buy everything ever made and render the impact of all other economies irrelevant. As we discussed in China Steel on Skulls, 3 we have no problem with the structural growth story and have been quite happy to ride the cyclical wave via our commodity and Hong Kong stocks biases. True, we have not been involved in the spivviest parts of the China-related stocks mania (though our tilts into other stellar performers such as India and Thailand have more than mitigated). But we do like to sleep at night and quite frankly, the quality of many of these counters is, and has always been, execrable. 3 November 22 nd 2003.
DSG Asia 5 January, 2004
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Growth momentum in both America and China should continue to be firm for the next few quarters Our near term concern, therefore, is that bond yields are set to back up steeply
Beyond H1, we have major growth sustainability concerns
But surely China will save the day?
Asia s Economic and Financial Market Landscape - 2004
Furthermore, investors can expect plenty more where these came from since with moribund domestic markets, and a whole new generation of foreign punters discovering China, the PRC authorities will be more than happy to offload assets onto the Hong Kong capital markets. We have seen such tsunamis or more accurately hai xiaos of issuance on regular occasions over the past decade and every time analysts have claimed that this time it is different. It never is and any analyst that utters such words should be roundly slapped in our opinion. The PRC starts off with the flotation of some semi-decent businesses but then rapidly rolls out all the dross that it has not been able to palm off on its own domestic investors. Expect further gains in H-shares for now but be aware that as from December 2003, you can now buy (and sell) Hang Seng China Enterprises Index futures. The first batch issued only go out to June 2004 so shorting now may not quite work. But we would posit that this will be one of the major trades to catch this year. We would reiterate that we are not expecting a China growth crash, though the reality of the slowdown in H2 will most likely be far more acute than the headline numbers reported. We are not alone in believing that the PRCs growth numbers are currently understated and an official slowdown from 9% plus to 7.5-8% is more likely to represent a deceleration something in the order of 12% to 7%. While it is still possible that the PBOCs tightening will be overruled and reversed in the coming months shades of Malaysia in 1995-96 and accordingly, it will be necessary to monitor closely the ongoing policy debate in Beijing, the measures introduced so far are already signalling slower growth ahead. In the three months to November 2003, loan growth has halved to an annualised 13%, and annualised broad money growth has similarly decelerated to 11%. The analogy we would use is of a petrol tank in a car. The engine can keep chugging along just nicely even as the tank is emptying but once the needle hits zero, the car just stops. A halving in the rate of new credit to infrastructure and other investment projects is likely to result in a sharp reduction in the rate of fixed capital formation growth, and since this represents a tad under half of GDP currently, the impact on the demand for all sorts of commodities could be severe. All of the above makes the call on the RMB, and by implication many of the other Asian currencies, all the more tricky. Our hitherto correct assessment has been that while Western commentators can huff and puff all they like, the Chinese have had no intention of budging on their exchange rate. More precisely, although we believe that Beijing has been amenable to moving away from its dollar peg over time, and has been actively studying different exit scenarios, it has not wanted to move a) in the context of being seen to
DSG Asia 5 January, 2004
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The structural story is a good one but the cycle has not been abolished
We are not expecting a China growth crash, though the reality of the slowdown in H2 will most likely be far more acute than the headline numbers reported
There is potential for a move to an RMB basket exchange rate
Asia s Economic and Financial Market Landscape - 2004
be bowing to foreign pressure and b) while global demand prospects have remained uncertain.
China: Official and DSG Asia Real TWI 140 130 PBOC Charted Real 120 Effective Exchange Rate 110 100 90 80 94 95 96 97 98 99 00 01 02 03
DSGAsia Real Effective Exchange Rate (CPI/PPI-based)
Our long held assessment has been that if global demand firmed through to But nothing seems the middle of 2004, and with it the Bush administration became more imminent confident about re-election and therefore toned down its protectionist and anti-Chinese rhetoric, then the PRC would consider a transition to a trade weighted basket exchange rate. An announcement in the Mainland press on December 22 nd 2003 has given some more credence to this view. The China Business Post, citing sources from the PBOC, reported that Chinas central bank is quietly moving ahead with a plan to peg the yuan to a basket of 10 currencies, instead of the US dollar alone. A prospective 10 currencies would represent the bulk of Chinas trade with the rest of the world as well as its main sources of investment. 4 The PRC does not publish any trade weighted exchange rates on a regular basis but last year the PBOC did present a graphical representation of its own calculated REER which in turn, we have plotted above against our own estimate. Our estimate is constructed 4 It seems highly unlikely that China would announce its official weights nor make them easy to fathom via simple quantitative analysis as per Thailand before the Asian crisis. The Singapore model would seem far more relevant.
DSG Asia 5 January, 2004
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Asia s Economic and Financial Market Landscape - 2004
comparing Chinas CPI to its trading partners WPI/PPIs (China does not publish such indices), and is weighted using moving export shares of its top eight major export destinations, 5 adjusted for re-exports via Hong Kong. As can be seen, the two estimates seem pretty close. The next chart below plots our nominal trade weighted exchange rate Until China does move, estimate (based on the same weightings) and adjusts it for two different the rest of Asia will scenarios going back to January 2000. The first scenario is based on a stable schoantdionwu et htoe ldarogllealry CNY/EUR over this three year period; the second allows the CNY/USD to incorporate 20% of the move in USD/EUR which is roughly equivalent to the euroland share in Chinas exports. We have not allowed for USD/JPY changes since this cross is today roughly where it was in January 2000. China Nominal Effective Exchange Rate Scenarios 130 130 Index January 2000 = 100 125 125 120 120 NEER Assuming CNY/EUR Stable 115 115 110 110 NEER Assuming 20% of USD/EUR move 105 105 100 100 95 95 90 90 85 85 80 80 00 A J O 01 A J O 02 A J O 03 A J O The first scenario is shown merely as an extreme and would have resulted in A move to a basket is N not going to produce a a 25% EER appreciation over the past three years. The second, more major USD/CNY realistic scenario produces just a 5% move. The point we seek to illustrate is realignment that ceteris paribus , a move to a basket is not going to produce a major USD/CNY realignment since the majority of Chinas major trading partners 5 In order of importance the US, euroland, Japan, Hong Kong, Korea, the UK, Singapore and Taiwan
Actual NEER
DSG Asia 5 January, 2004
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Asia s Economic and Financial Market Landscape - 2004
are dollar denominated too. However, if such a shift does occur, then it seems pretty likely that other Asian countries will feel more comfortable about allowing their exchange rates to appreciate against the dollar in line with the RMB. We will discuss specific positioning towards the end of this article when we set out our recommendations for the year. Before we move on, there is another dollar Asia scenario that needs to be considered in the event of the US economy rolling hard again and the administration seeking to trash the dollar in desperation. Asian central banks have hitherto been happy to accumulate US Treasuries while the dollars depreciation has been orderly. In recent weeks there have been signs that the PBOC has been losing its appetite but fortunately for America, Japan remains insatiable for now. The MoFs recent announcement that it will raise the amounts it can borrow for intervention from JPY21 trillion to JPY100 trillion this financial year to March 31 st , and from JPY61 trillion to JPY140 trillion in fiscal 2004-05, signals that it has no attention of allowing a huge Yen appreciation. At least not while the Chinese and other Asians are standing pat. However, if a dollar decline started to become a dollar and bond market rout, and if the attendant consequences caused a hard landing in the Chinese economy and with it local attitudes towards the RMB reversed, it could get very messy indeed. Every road seems to bring us back to gold. Tricky, tricky, tricky. Our general profile for growth is strong globally through to mid year and still accelerating in non-China Asia. The profile for asset returns could be far more capricious though. We see a strong start to the year for Asian equities on the back of further foreign inflows and domestic investors becoming less risk averse. The risk is then a bond sell-off which could lead to a nasty pullback given the speed of the rises seen over recent months. This in turn could provide another decent window for equities and also for re-establishing long rates trades in the region. But then we rather fear that all hell breaks loose. As for currencies we remain short the US dollar but our hitherto preferred vehicles of expression, AUD and NZD could be rather vulnerable to any diminution in the China love affair. Especially if the softening in the housing market in Australia gathers pace. We are letting these positions ride for now though we are closing out our long AUD/NZD trade since this cross has more or less normalised now we believe. However, we could be in for a roller coaster ride and conceivably we might see a path for the USD/AUD something like 0.80 to 0.65 to 1.00 over the next two to three years.
DSG Asia 5 January, 2004
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If a dollar decline started to become a dollar and bond market rout it could get very messy indeed
A highly opportunistic and market timing focus will most likely be required
The AUD and NZD could be rather vulnerable to any diminution in the China love affair
Asia s Economic and Financial Market Landscape - 2004
To finish up, we will take a quick tour around the rest of the region, starting with Japan. We have had a positive cyclical view of Japan since early last year and an even more positive micro view based on a burgeoning profit share shift in GDP from the household to the corporate sector. We continue to believe that a combination of companies continuing to squeeze labour costs in the context of improving top line demand means that profits expectations still have further to be revised upward. Moreover, although real wages are under pressure, consumers seem to be dissaving to maintain current consumption patterns, and are increasingly re-engaging in the real estate market in response to much improved affordability and the long overdue introduction of changes to the tax code. Nevertheless, financial assets have traded disappointingly in recent months and local interest in stocks remains notably absent. Having gone back and re-examined all of our assumptions, our conclusion is still to remain engaged at least until the external environment starts to turn less friendly. As for the Yen, it may grind up further but do not expect major fireworks in the immediate future. Similar external demand drivers in the context of weak but slightly improving domestic economies characterise our Taiwanese and Korean views. As we explained at length last month, from a macro perspective we prefer the former but President Chen Sui-bians antics have substantially raised the political risk profile. By default, therefore, we prefer to capture international fund flows theme via Korea albeit we do not particularly like ourselves for saying so. Our warnings about the underpricing of North Korean risk proved to be unfounded last year but we believe that they remain just as valid this. Moreover, stress has not been taken out of the financial system but is merely being shuffled around as evidenced by the resurrection of the kerb market. This had all but disappeared after Korean individuals and small company owners discovered the wheeze of funding their current spending and working capital requirements via credit card advances. With these advances being called in now, the old fashioned loan sharks are back in business and charging rates of 3-400% from what we can understand. We will run the long equity trade to try to catch the asset reallocation trade this month note though that foreigners already own almost 40% of the market but we intend to cut and run pretty quickly. We have discussed China at length already so we will not tarry here save to mention that out one-month opportunistic long USD/CNY forward position failed to benefit from the year end position closure squeeze we were looking for. We continue to look for our PRC exposure via higher quality Hong Kong counters, though we recognise the risk of underperformance while China mania reigns.
DSG Asia 5 January, 2004
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We have had a positive cyclical view of Japan since early last year and an even more positive micro view
Korea is slightly less bad near term than Taiwan
We continue to look for our PRC exposure via higher quality Hong Kong counters
Asia s Economic and Financial Market Landscape - 2004
India remains our favourite macro and micro story in the region and in the 14-15 years we have been covering the place, this is the first time we have ever held a structurally bullish view. The political environment is conducive towards more stable and enabling government. There is scant evidence of the overcapacity seen elsewhere and fixed investment in both plant and machinery and infrastructure are picking up nicely. Despite a still worrisome budget deficit, the cost of capital has come down markedly while new avenues of funding for both the corporate and household sectors are mushrooming. And unlike in China, there is a wide range of decent and well run companies to choose even if one still needs to watch ones back for sharp practices. What are the potential negatives? At the political level, Pakistans President Pervez Musharraf seems to be living on borrowed time and a successful assassination attempt might take the wind out of a market temporarily at least that has gone up in a straight line since the middle of last year. Government bond yields have overshot on the downside and one can expect a bear steepening of the yield curve in the coming months. The next monsoon may be a shocker. And we suspect that India might increasingly become a target for protectionist rhetoric and actions as trends in white collar outsourcing continue. We have argued on a number of occasions that India may increasingly be seen as posing an even greater threat than China to developed economies, since it has the potential to undermine the cosy lives of middle class professionals. It is a bit rich when the President of the IT Professionals Association of America you know, the fellows that have been championing a borderless e-world and open standards feels compelled to write to The Economist asking for restrictions on the activities of Indian firms. 6 But it is worrying nonetheless since whines from such quarters justified or not are more likely to be heard at a political level. The fear runs deep for as a financial services contact of ours caustically remarked the other week, Im going to persuade my kid to become a plumber because then he cannot be outsourced. All of the above are risks for sure but on balance, we still expect financial assets to perform well. Especially, if the locals start to put their punting shoes back on. In ASEAN, we wrote on Singapore at length at the end of last year and are happy to resend the article to those of you who had already gone off on holiday by then. 7 While equities should do OK in the context of strong 6 See the letters page of the December 6 th 2003 edition. 7 See: Singapore Relative Mispricing in the Government Bond Market, December 15 th 2003.
DSG Asia 5 January, 2004
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India remains our favourite macro and micro story in the region
There are risks for sure but on balance, we still expect financial assets to perform well
