Equity markets in Asia ended generally lower in the second quarter of 2013 due to concerns over the U.S. Federal Reserve’s apparent shift towards a more balanced monetary policy stance following Chairman Bernanke’s statements suggesting a “tapering” of its asset purchase program. China’s weak economic numbers also undermined investor sentiment in the region. In Japan, the announcement of Prime Minister Abe government’s “third arrow” policies, or growth and private investment strategy, fell short of market expectations. The MSCI AC Asia Pacific Free Index including Japan fell 3.03% while the MSCI AC Asia Pacific ex Japan Free Index closed 7.6% lower during the quarter. (All performance figures are based on MSCI indices in U.S. dollar terms with dividends included unless otherwise stated.)
The Tokyo Stock Price Index (TOPIX) extended its rally during the April-June quarter, gaining 9.6% as market participants initially responded favorably to the new monetary policy launched by the Bank of Japan (BOJ) in April, supported by massive inflows to the Japan equity market from international investors. However, the momentum later waned amid growing concerns over the global economic prospects. After a turbulent May, the TOPIX fell slightly in June, ending the month 0.2% lower. While growing awareness of a possible exit from quantitative easing (QE) in the U.S. led to signs of weakness in the global equity markets, concerns over the sustainability of economic growth and doubts about the stability of financial conditions in China had a negative impact on investor sentiment. The extent of asset purchases announced by the Bank of Japan in April exceeded market expectations and the presentation by the new governor was clear and unambiguous in its delivery, which seemed to differentiate Governor Kuroda’s style from that of his predecessors. Meanwhile, the Yen continued to weaken relative to other major currencies on the back of this aggressive monetary loosening policy.
Macroeconomic figures point to a gradual recovery. Industrial production suggested that corporate manufacturing activity was bottoming out, as the figures in March, April, and May were +0.2%, +1.7%, and +2.0% month-over-month (mom), respectively. Analysis of these forecasts suggests a slowdown in production activity in June, but this could be followed by a recovery in July. Labor market conditions also improved gradually. The active job opening ratio was 0.90 in May, improving from 0.86 in March. Meanwhile, deflationary conditions continued to ease somewhat. The National Consumer Price Index (CPI) was -0.3% year-over-year (yoy) in May, but the negative margin narrowed from -0.9% in March. National Core CPI (CPI excluding fresh food) was 0.0% (yoy) in May, rising from -0.5% at the end of the first quarter.
A surge in trading volume supported the major securities brokers, while real estate related companies received another boost from the new monetary policy shift. Therefore, the Financials sector and the Infrastructure sector, which includes the real estate sub-sector, led the market rally through April. Meanwhile, the Commodities sector lagged behind the market amid weaker global demand and lower basic material prices. Export-oriented sectors outperformed during the review quarter along with the weakening Yen, especially the Automobile and Electronics sectors. These exporters have shown superior earnings momentum, with production levels bottoming out, successful efforts to reduce inventory levels last fiscal year, and growth in overseas sales and earnings driven by the weaker Yen. Meanwhile, the Communication sector also outperformed and started to close the performance gap.
The MSCI China Index fell 9.1% during the quarter as economic data such as the Purchasing Managers’ Index failed to match expectations, while rising interbank rates suggested that the government is not being as accommodative as investors had initially thought. Sectors that are highly sensitive to the economy such as Materials (-22.8%), Energy (-19.4%) and Financials (-11.3%) led the decline. On the other hand, the best performing sectors were Information Technology (+15.9%) and Consumer Staples (+3.5%). In the MSCI Hong Kong Index (-5.9%), sectors which underperformed were Utilities (-7.5%) and Financials (-7.4%).
The MSCI Australia Index (-12.8%) was the worst performer in the region largely due to the weakness in the Australian dollar which depreciated 12.2% against the U.S. dollar during the period. Materials (-20.1%) was the worst hit sector while Telecommunication Services (-7.1%) was the best performer in Australia.
The MSCI India Index declined 6.2% during the month, led by the Information Technology (-17.9%) and Materials (-15.1%) sectors. On the other hand, Telecommunication Services (+8.7%) was the top performing sector.
The MSCI Korea Index (-10.0%) underperformed the region during the period with Energy (-20.4%), Healthcare (-18.7%) and Utilities (-17.1%) being the weakest sectors. The only sector that ended in positive territory was Telecommunication Services (+21.0%). The MSCI Taiwan Index (+1.6%) outperformed and showed a similar trend, with Telecommunication Services (+12.7%) the best performing sector, followed by Consumer Staples (+7.2%) and Consumer Discretionary (+5.1%).
In the ASEAN (Association of Southeast Asian Nations) region, Malaysia (+4.9%) was the top performing market in Asia with all sectors closing higher, led by Energy (+20.1%). Thailand (-9.6%) underperformed the region with the Consumer sector being the worst hit. In Singapore (-7.6%), property stocks with exposure to China came under pressure.
Market Outlook and Strategy
Our positive view of Asia Pacific equities has been severely tested over the past two months, with sharp declines experienced in all regional markets. We were especially surprised by the vehemence of the sell-off that followed remarks by the U.S. Federal Reserve Chairman signaling that the U.S. economic recovery had gained sufficient traction to a allow a “tapering” of QE to be considered. However, we must respect the market’s reaction that suggested there were more weak holders of Asian equities than we had supposed.
There is no doubt that liquidity conditions may become less favorable, but in any historical context they could remain highly accommodative. Our base case scenario maintains that for a number of structural reasons, largely associated with de-leveraging, global growth may be slower than it has been in past recoveries. This leads us to believe that the Federal Reserve’s unemployment and inflation targets for an end to QE may not be realized for a number of years.
We also dismiss those commentators who are looking for similarities with the Asian region of 1996, just before the Asian crisis. Yes, the credit cycle is well advanced and loan growth has accelerated. However, the key variable – the ratio of short-term debt to official reserves - is way below danger levels. Aggregate current accounts are also still in surplus and loan to deposit ratios lie generally around or below 100%.
Of more concern is the outlook for China. The policy of using fixed-asset investment as the primary tool to drive growth has reached its limits. Its preferred replacement is well known and recognized by the government – that is a combination of increased private consumption and a renewed reform drive to allow private sector growth. However, like all reforms, its implementation is fraught with difficulties, as it is those in powerful positions that have the most to lose. This transition, if it indeed occurs, could also be associated with growth levels far below the current consensus and this could have adverse implications for other regional economies, especially those exporting resources to the mainland.
The Pacific Basin markets have entered what we call a mid-cycle correction. This occurs when economic leadership shifts from countries with strong internal growth drivers to those benefiting from global economic activity, and from interest rate sensitive and defensive sectors to those companies that benefit more from structural growth prospects. Such periods can last for several months and can be quite volatile as investors reposition their portfolios.
With regard to country allocations, we have been adding to the Taiwan position. The country is benefiting from stronger cross-strait relations and a decline in commodity prices. Management is generally very entrepreneurial with strong capital discipline, and many companies are sensitive to U.S. economic growth. Finally, the much maligned capital gains tax has been reengineered and may only impact the wealthiest individuals.
There are still very good reasons to remain underweight in China. The reform process could likely hit the State Owned Enterprises, which have thrived in the existing environment. Going forward, we will focus more on the smaller private sector stocks that could be the ultimate beneficiaries of a more market oriented economy.
Our largest overweight exposure continues to be the smaller ASEAN markets of Thailand, the Philippines and Indonesia. These markets, and currencies, bore the brunt of foreign selling. At one stage during the month, the Philippine market was down 22% when measured in U.S. dollars. However, we were heartened to see local institutional and retail investors reenter the market and help to limit the eventual fall. However, with valuations in ASEAN stocks having already outperformed massively, it is difficult to see the next stage of the Asia bull market being driven by these markets. This will require the North Asian markets to take the lead, and while this will be a long process, we have started to reposition the portfolios accordingly. Meanwhile, we have increased our exposure to Malaysia, as improvement in political situation will continue to bode well for economic reform.
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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.
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