OVER AND OVER again, investors nowadays are being told that emerging-market assets will outperform developed ones for a long period to come — and that within emerging markets, it will be Asian assets that will do relatively better. The global crisis, it is argued, devastated the G3 — the US, Europe and Japan — leaving their consumers, financial institutions and public-sector finances in shambles. Asia, on the other hand, will enjoy the synergies from the simultaneous rise of China and India — an advantage that other emerging-market regions do not possess, so we are told. Consequently, it is taken as a given that emerging Asian assets are the place to be for global investors. When a view is repeated like this almost as a mantra, investors would be wise to question it. The likelihood is that such an opinion is too simplistic and investors should incorporate into their investment strategy a more nuanced view.
THE CASE FOR ASIAN OUTERPERFORMANCE
There are some reasonably persuasive grounds for expecting Asian assets — equities and real estate — to do exceptionally well. First, the G3 economies are likely to suffer a larger fall in economic growth in the next few years than Asian economies.
Image: The Bombay Stock Exchange rises in the background of a street in Mumbai, India. The country’s growth is cited as one reason Asian stocks will do better than the rest. Credit: Bloomberg
This is because domestic demand in the G3 will be constrained by factors that will not be much in evidence in Asia. G3 consumer spending will be hamstrung by high unemployment, which will limit income growth and curtail confidence. Capital-scarce banks in developed countries will not be lending as easily to consumers at the lower end of the income spectrum, unlike before, and wealth effects from a rising housing market are hardly likely to boost spending.
Given this sombre outlook, businesses will hesitate to expand capacity, limiting capital spending as a driver of growth as well.
Also, the public sectors in the G3 will almost certainly be subtracting from growth, as the process of budget- deficit reduction will take a long time to work out.
For Asia, economic growth might slow a bit, compared with pre-crisis days, because the G3 prospects described above will keep external demand weak. But, domestic-demand engines are likely to be revved up as a result of a strong labour force and productivity growth fuelled by positive demographics, the shift of workers from rural to higher-productivity urban jobs, adoption of new technologies, improving infrastructure and synergies from continued deregulation and regional integration. Asian economies in general will face fewer of the balance sheet constraints in household and financial sectors that are hurting the G3.
Second, at some point in the next year or so, China will probably have to revert to a policy of gradual currency appreciation. This will give other Asian economies more space to allow their currencies to appreciate as well, since the competitive challenge from China will be less of a threat. Rising currencies will naturally add to the returns that Asian assets can generate for investors.
WHAT ABOUT THE DOWNSIZES?
There is much truth in the arguments above, but there are several reasons why investors should still rigorously question them.
First, if superior economic growth were the key to outperformance, Asian assets should have been outperforming for a very long time now — but this has generally not been the case. Higher economic growth probably provided a good basis for superior realestate price appreciation rather than equity-market outperformance. The higher incomes, increasing sophistication of mortgage lending and increased relative scarcity of land as economies grow rapidly are good arguments to expect real-estate prices in Asia to do better than those in developed economies over the long term.
But, there have been long periods of extraordinarily superior economic growth in Asia during which equity prices in Asia did not necessarily do better than equity prices in developed economies. From 1982 to 2001, equities in the US performed strongly, compared with Asian equities, even though US GDP growth was lower. Asian equities rose spasmodically and then collapsed spectacularly in 1997, with depreciating currencies adding to the pain.
Second, economic performance is not the key to equity-market performance, but how companies in one market perform compared with companies elsewhere is. There are many reasons why corporate-sector achievements could turn out to be poor, even when their economies are doing well:
- Poor business ethics and weak governance could result in corporate profits not matching economic performance in a given country. Corporate governance and supervision remain relatively weak in many parts of Asia compared with the developed world. We only need to remember the spectacular collapse of Satyam in India and the nightmares that local investors in S-chips have suffered to realise this.
- It could also be the case that it is unlisted companies that generate high growth and not the listed companies that investors can buy into. For example, in Singapore and many parts of Southeast Asia, a good part of GDP growth is driven by multinational companies or government-owned companies that are not listed.
- Asia has gone through a recent period during which the profits-to- GDP ratio has risen at the expense of the wage share of the economy. Rising profits are, of course, good for equity markets. But, history teaches us that such worsening income distribution usually produces a political backlash that results in taxes, regulations, stronger trade unions and other policy changes that eventually claw back labour’s share of income. Thus, one could well get a period when economic growth is high, but profit growth is limited by a rising wage share. We suspect Asia could be entering just such a period.
Third, high growth is often accompanied by accelerating inflation or overheating, specifically in the form of deteriorating current-account balances or asset bubbles. Any of these deve lopments would precipitate monetary tightening, which would undermine equity-market performance.
Finally, most Asian economies remain relatively less developed in terms of their macroeconomic policy regimes and regulatory/supervisory practices. This leaves Asia susceptible to bubbles and busts. Recall that even with the salutary lessons of the 1997/98 Asian financial crisis, several Asian countries (including the more sophisticated South Korea) stumbled into a credit-crisis bubble just a few years later.
ASIA’S A GOOD STORY, BUT…
The above reasons do not argue for avoiding Asian equities. Investors will always want exposure to growth stories and there will be many opportunities in Asia. But, investors do need to be wary of simple-minded arguments for better returns in Asia relative to the world. They need to look hard at the companies they buy into and remain alert to signs of poor governance, overheating or policy changes that could hurt equity prices. And, they need to understand that even as Asian economic growth exceeds that in other regions, there will be periods when those other regions could still deliver superior asset returns.