The downgrade by Standard and Poor’s of the United States’ sovereign debt rating at the beginning of August triggered a worldwide equity market sell off that sent all of the Asian indices lower during the review period. The MSCI AC Asia Pacific Free Index including Japan and the MSCI AC Asia Pacific ex Japan Free Index ended the month with losses of 8.63% and 8.93%, respectively.

The Tokyo Stock Price Index (TOPIX) declined 10.26% in local currency terms in August against a backdrop of deepening uncertainty about the prospects for the global economy. With no immediate prospect of a resolution to the sovereign debt issues in Europe and a surprise downgrade to the credit rating of the United States by Standard & Poor’s, market sentiment deteriorated rapidly and therefore weighed on global equity prices.

Unexpectedly weak U.S. economic indicators, such as the ISM (Institute of Supply Management) Manufacturing Index and consumer spending data, suggested that the Federal Reserve would have to maintain its historically low interest rates to revive the economy, which fuelled further gains in the Japanese yen. Subsequent currency market intervention by the Bank of Japan had little lasting effect and the yen started to appreciate again toward the end of August. The equity market was understandably concerned about the impact of persistent currency strength on exporters.

The post-disaster recovery in output appears to be losing pace. Industrial production growth in July decelerated to 0.6% month-over-month (mom) compared with the 3.9% growth for June. In the meantime, the survey of production forecasts suggested a near-term drop in production activity, with figures of +2.8% (mom) in August and -2.4% (mom) in September. This figure could indicate deteriorating conditions in the overseas economies and concerns about the strengthening yen among export-oriented manufacturers. Corresponding to the weak output prospects, nominal exports in July extended their decline of 1.6% year-over-year (yoy) in June, decreasing 3.3% (yoy) partly due to a sluggish recovery in exports of general machinery. Meanwhile, the domestic economy remained lackluster. Real consumer spending declined by 2.1% (yoy), while core Consumer Price Index (CPI) in July posted a small gain of 0.1% (yoy).

Reflecting these deteriorating external conditions and the strengthening yen, export-oriented sectors including Electronics, Automobiles, and Capital Goods underperformed in August. Similarly, the Commodity sector’s performance was also weak due to a subdued outlook for commodity prices. In contrast, the defensive sectors such as Consumption and Medical performed steadily amid the market downturn.

Korea was the worst performing market this month, with a 13.4% decline in the country index. The Energy sector led the declines, with refinery stocks suffering a 20% drop after decreasing oil prices were expected to translate into inventory losses. However, internet and gaming stocks outperformed, as investors switched into stocks with relative stable earnings. The MSCI Taiwan Index declined 9.8% in August. Consumer staples continued to outperform on stable earnings.

Despite an up-tick in China’s official manufacturing Purchasing Managers Index (PMI) (50.9 in August from 50.7 in July), MSCI China declined by 9.4%, led by declines in the Materials (-13.6%) and Industrials (-13.3%) sectors. China’s CPI also accelerated in July, rising to 6.5% (yoy) from 6.4% in June due to higher food prices. Defensive sectors such as Telecommunications (+2.3%) and Utilities (-3.2%) outperformed during the period. MSCI Hong Kong showed a similar trend, with defensive sectors (Telecommunications and Utilities) outperforming. Hong Kong outperformed the regional index, with a relatively limited decline of 6.4%.

Australia outperformed the region with the MSCI benchmark declining by 5.3% in August. Outperformance from the Telecommunications (-1.2%), Consumer Staples (-2.9%), and Financials (-3.9%) sectors contributed. Energy and Materials sectors detracted most from the country performance. India, on the other hand, underperformed the region with a benchmark decline of 12.5%. Cyclical sectors such as Information Technology were hit hardest as the demand outlook remained weak.

The ASEAN (Association of Southeast Asian Nations) markets also witnessed a sell-off this month, although they broadly outperformed the regional index. Singapore decreased by 10.6%, Malaysia and Thailand both lost 8%, and Indonesia lost 7.9%. The Philippines was the best performing market, with a monthly decline of just 4.6%. Industrial stocks in Singapore were hit by the weakening order outlook. Materials (-14.2%) and Industrials (-10.2%) in Thailand were the worst performing sectors.

 

Market Outlook and Strategy

The global economic environment seems to be deteriorating rapidly. European economies are increasingly weighed down by the de-leveraging of the peripheral countries, while confidence in the U.S. is being sapped by the political paralysis in Washington. As a result, we have significantly downgraded our economic forecasts. For the U.S. economy, we are now predicting 2.0% real growth for 2012. However, we still believe that a double dip recession can be avoided.

Asian economies will inevitably feel the impact of this economic turmoil given the importance of exports to many countries in the region. In the short term, the stock market will also succumb to repatriation of capital by nervous foreign investors.

However, we expect this weakness to be short lived and we believe Asia Pacific markets will once again outperform. While we can expect to see a slowdown in earnings growth though the remainder of 2011, equity valuations are extremely low in general and have already incorporated much of the bad news. In addition, interest rates are still too low relative to growth rates. This will continue to support asset prices in the region.

Our country selection remains unchanged, with overweight positions in the smaller ASEAN markets due to their greater domestic orientation, and underweight positions in China and Australia. The former is overly dependant on skittish foreign investors while Australia, and its currency, are highly sensitive to global economic growth.

The focus of our analysis will be to look closely at corporate earnings forecasts in this environment of slowing economic growth. We expect to see some downgrades. Stocks that are over-owned by foreign investors and trading at premium P/E ratios will be especially hard hit by poor results. Conversely, cheap stocks with low foreign ownership are likely to outperform, in some cases dramatically, if their earnings meet or exceed consensus expectations.

 

International investing involves certain risks and increased volatility not associated with investing solely in the U.S. These risks include currency fluctuations, economic or financial instability, lack of timely or reliable financial information or unfavorable political or legal developments. These risks are magnified in emerging markets. Securities focusing on limited geographic areas and/or sectors may result in greater market volatility. Investing in securities issued by smaller companies typically involves greater risk than investing in larger, more established companies.

 

Investors should carefully consider the investment objectives, risks, charges and expenses of each Fund before investing. This and other important information is contained in the Nomura Partners Funds, Inc. prospectus, which may be obtained by contacting your financial advisor, by calling Nomura Partners Funds at 1-800-535-2726, or visiting our website at nomurapartnersfunds.com. Please read the prospectus carefully before investing.

 

This material contains the current opinions of the author, which are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information used to compile this report has been obtained by sources deemed to be reliable, but its accuracy and completeness are not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Past performance is no guarantee of future results.

 

MSCI AC Asia Pacific ex Japan Index is an unmanaged free float-adjusted market capitalization index that is designed to measure the equity market performance in the Asia Pacific region excluding Japan. The Tokyo Stock Exchange Price Index (TOPIX) is an unmanaged capitalization weighted measure (adjusted in U.S. dollars) of all shares listed on the first section of the Tokyo Stock Exchange. One cannot invest directly in an index. P/E (price-to-earnings) ratio is the value of a company’s stock price relative to company earnings.

 

The MSCI information contained in this material may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.

Investments are not FDIC-insured, nor are they deposits or guaranteed by a bank or other entity.

 

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