Market Commentary
by Byron Wien
 
07/11/2013

Asia Is Reaching a Turning Point

I spent almost two weeks in Asia in June and in some ways it was an eye-opener.  In past years there was a sense of optimism everywhere you went.  Now you get a feeling of uncertainty touched by apprehension.  My trip covered a great circle starting in Singapore and going on to Kuala Lumpur, Taipei, Hong Kong, Beijing, Seoul and Tokyo.  Spending only one day in each city, my observations were more impressionistic than analytical.  I talked with sovereign wealth fund managers and other major investors.  Most concerns related to China’s outlook and whether the financial system there was overextended.  As we all know, China is the engine of growth for the region and any problems there are felt everywhere else.  In contrast to last year, Japan was also a major topic of interest.

Singapore today is experiencing the worst pollution in its history.  Farmers in Sumatra are creating more arable land by burning some of its forests.  The prevailing winds have carried the smoke to the Malaysian peninsula, causing the Pollutant Standards Index to reach 371; anything over 300 is considered dangerous.  There is a thick gray haze covering the city and many are wearing white masks over their mouths and noses but since the stores are sold out of these, people are trying to stay indoors as much as possible.  It was hard to breathe and my voice was hoarse during all my presentations.  Air pollution is almost a way of life in Shanghai and Beijing.  Many business people have chosen to locate in Singapore for the health of their families, particularly if they have young children, so the current situation is ironic.  Nobody seems to know how long the problem will last and negotiations between Singapore and Indonesia are making slow progress if any.  The haze is not only a practical hazard, it is symbolic: you can’t take the future for granted in Asia today; there are unexpected events that can change the circumstances at any time.

Malaysia today bridles at not being taken seriously.  Like most Asian countries, it has grown enormously in the past three decades.  Kuala Lumpur, while also suffering the Sumatra pollution, is an impressive modern city, although its thoroughfares have not kept up with the modernization of its office and residential construction.  With substantial natural resources, an educated population and low unemployment, many Malaysians wonder why more investors don’t focus on opportunities there.  One differentiating factor is that women in Malaysia hold many high positions in finance. And, from my experience, they ask the best questions at meetings.  It’s as if they have all read Sheryl Sandberg’s book; they speak up and “lean in.”

I was struck by how globalization has homogenized the consumer brand culture.  I visited an immaculate upscale mall and almost every high-end international clothing and accessory label from Armani to Zegna was represented by a large, well-appointed shop.  Tiffany was there but Ralph Lauren and Hermes were absent; they may have shops elsewhere.  When I first started traveling abroad more than half a century ago, I used to prowl the streets peering into the shops with names I had never heard of.  It is still possible to do that, but high fashion has gone international.  It may get to the point where everyone in the top 1%, or perhaps even the top 10%, everywhere begins to look similar because they buy their stuff at the same places.  By the way, the mall was packed.  I don’t know whether all the people were buyers or gawkers, but there was plenty of traffic and some of the shops appeared to be doing a good business.  Clearly not everyone goes to Hong Kong to load up.  The growing Malaysian middle class is active at home.

The critical problem in Asia is tied, not surprisingly, to China.  While Chinese Real Gross Domestic Product (GDP) growth was reported at 7.7% in the first quarter, although some have suggested that the underlying rate was less than that.  I have been watching electricity consumption carefully.  While this is a volatile indicator, it is hovering in low single digits, suggesting that momentum in China is slower than many believe.  Foreign direct investment was only up 1% in the first five months of 2013 compared to a year ago and it was down in 2012.  Several years ago China’s major problem was believed to be overbuilding of apartments and offices.  There were supposedly empty cities and a real estate collapse was widely predicted.  It didn’t happen and today a survey of prices for residential real estate in 100 major cities shows a clear uptrend.  The current major problem is non-performing loans at the country’s banks and so-called “shadow banks.”  This weakness in the financial system has been with us for some time, but the People’s Bank of China has been willing to provide the liquidity necessary to keep the banks functioning, even though a significant proportion of loans in the system might be in default.  Recently the banking authorities have decided to restrain what they believe to be irresponsible lending and this has raised further questions about whether the economy can grow at high single-digit-rates without easy credit.

When the Chinese interbank lending rate rose to 13% in June, investors feared that a period of tight credit might be starting.  The prevailing view among knowledgeable observers in the region is that imposing some discipline on the banking system is the first step that China’s new leaders are taking to put the economy on a sounder longer-term footing.  Other steps will include implementing serious measures to control corruption.  Even the optimists, however, expect the changes to be slow in coming.  There are other signs of weakness in the Chinese economy.  The manufacturing purchasing managers’ index dropped to 48.3 in May from 49.2, indicating a further slowdown in industrial activity.  The People’s Bank of China survey of financial institutions was also weaker and that is showing up in loan activity.

The biggest challenge to China’s two new leaders is the rebalancing of the economy.  In an effort to improve exports and build hard currency reserves, China made heavy investments in state-owned enterprises producing goods to be shipped abroad and also improved its infrastructure.  In 1999 the consumer component was 46% of Chinese GDP.  By 2010 it was down to 35% and investment spending was 45%.  The five-year plan introduced in September 2010 set a goal of bringing the consumer back to 45% and reducing investment spending, but little progress has been made on that rebalancing goal.  There are plenty of goods on the shelves of stores, but Chinese consumers seem reluctant to spend.  Older people save for their retirement and healthcare expenses and younger families save for the education of their children and to buy a house or apartment.  Incentives may have to be provided to stimulate consumption.  If the economy is not rebalanced China will have to continue to rely on exports for growth.  With Europe still in a recession, the U.S. growing at 2% and most of the developing world slowing, exports may continue to be disappointing.  China’s new leaders have said they are focused on implementing reforms.  Achieving a high level of growth is not their primary goal.

Concern about a slowing of monetary expansion in the United States is also affecting the markets and economies of Asia.  Fed Chairman Ben Bernanke’s picture appears in every newspaper almost every day.  Asian investors know that the markets in the developing countries do well when U.S. equities are rising, but during the first five months of 2013 the Standard & Poor’s 500 rose more than 15% and Asian markets struggled.  Now that a correction has taken place in U.S. stocks, investors in the region are particularly perplexed.  They see that monetary expansion has driven the American market higher and they argue that since inflation is low and below the Federal Reserve target, growth is modest and the unemployment rate is nowhere near the 6.5% objective, the Fed should keep easing. 

I tried to explain that monetary expansion is a very inefficient way to stimulate the economy.  By my estimation three-quarters of the money goes into financial assets, driving stock prices higher and bond yields lower.  Only one-quarter of the money goes into the real economy.  The Fed hopes some of the owners of equities spend their stock market profits, but that process is very indirect.  The one aspect of the stock market that is relevant to the Fed is consumer net worth, which has risen substantially since 2009.  Most of this, however, has accrued to the top 20% of the population, which has a significant portion of its net worth in equities.  The vast majority of Americans have not benefited to the same extent.  The Fed doesn’t want the economy to become addicted to easy money.  It wants to wean the economic system from liquidity dependency and let it develop some momentum on its own.  I do think, however, that a generally expansive monetary policy will continue in the U.S. for some time. 

While South Korean investors know that an unpredictable North Korea lies immediately beyond its border, few seem preoccupied by fear.  Their concerns are more related to the weakening yen, and what that means for Korean exports, and to the pace of China’s growth, since their huge neighbor to the south is one of their major customers.  They are suspicious of the monetary and fiscal stimulus programs underway in Japan, believing that a bubble may be forming there which will cause reflective damage in Korea.

The outlook for the Japanese economy and its stock market became constructive last fall and this view continued through May.  It seemed that Shinzo Abe’s plan to stimulate the economy through fiscal and monetary policy was working.  The declining yen had improved exports and there was a general feeling that growth and inflation would be positive next year.  The long deflationary recession might finally be ending.  On June 5, Abe made a speech about the “Third Arrow,” which was regulation; the first two arrows were fiscal and monetary policy.  Investors expected the announcement of a specific program but he was vague, setting off a sharp decline in Japanese equities.  This was followed by Ben Bernanke’s comments about reducing the bond buying program in the U.S., and both financial assets and commodities declined around the world. 

The need for reduced regulation in Japan is clear.  Agricultural groups and small shopkeepers have had enormous influence on the growth of larger businesses.  Abe has promised policies that will be favorable toward technology but he has not been sufficiently specific on that point either.  He is proposing an increase in the consumption tax from 5% to 8% and ultimately to 10%, which would clearly hurt growth but might stimulate near-term buying.  There is continued friction with China over the disputed possession of the Senkaku Islands and Japanese direct investment has migrated south to other smaller Asian countries.  An election takes place on July 21st and Abe is likely to win by a substantial margin.  The expectation is that this will give him the confidence to continue his program to restore growth to Japan.  I’m hoping that will happen.

Overall I would say that Asian investors are somewhat more complacent than they should be given the clouded outlook for China.  They don’t display the limitless optimism of previous years, but they believe they are in the right place at the right time.  If there is an underlying fear it is that there could be some kind of crisis in China.  It could be caused by a lack of jobs for younger people coming out of school.  It could be caused by a partial meltdown of the banking system that could result from bad loans and not be containable by the People’s Bank of China.  It could be caused by a political action.  The fear is that the situation is tenuous, and that is in sharp contrast to the view that strong growth could continue indefinitely, the mood of past years.

I have spent four of the last six weeks abroad: two in Europe and two in Asia.  My conclusion is that the outlook for Europe has become more positive because the commitment to austerity has diminished and growth is now the objective.  The Asian outlook has changed because of China’s uncertainties.  I remain optimistic about developments in Japan.

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