BT: Asia can sustain the secular bull trend (31 Oct 2007)

Asia can sustain the secular bull trend

The China/India theme likely to have a positive impact on the rest of Asia as it is helping to underpin intra-regional trade

By DR SHANE OLIVER

FOR some time we have been of the view that the global equity bull market that commenced in March 2003 has entered a more exuberant phase. If it has, the next question to ask is where investors will focus their exuberance. Cyclical bull markets go through three stages:


- A recovery phase from excessive pessimism, which characterised the initial share rally in 2003;

- An earnings-driven phase where strong earnings growth drives share prices higher. This has essentially been the case since late 2003 into this year; and

- An exuberance-driven phase where share prices rise faster than earnings as increasingly optimistic investors push share valuations to extremes.

The third stage can last for years as was the case in the late 1990s in the US where IT stocks became the focus. Our assessment is that we have now entered stage three, but we are a long way from reaching the extremes that normally characterise bull market tops. Stage three is characterised by slowing profit growth, rising price-earnings (PE) multiples, rising volatility as more investors become exposed and shares start to lose some of their earnings support and increasing investor exuberance for a key investment theme (or themes) which results in a narrowing of participation in the market's advance. The first three are now arguably evident: Profit growth is slowing in most regions; PEs are rising helped by US monetary easing - lower interest rates make shares more attractive relative to cash and hence usually result in higher PEs; and volatility is on the rise. This is clearly evident in the increasing severity of share market corrections.

For example, corrections in the Australian share market are becoming more severe: a 3.5 per cent dip in 2004, two 8 per cent corrections in 2005, a 12 per cent fall last year and a 14.8 per cent decline in July/August this year. And after a huge rebound since mid-August, it looks like share markets are now undergoing another correction, although this one should be more modest than the falls in August as the Federal Reserve continues to cut interest rates.

Focus of investor exuberance

But the big question is what will be the focus of investor exuberance this time around? Every decade seems to end with some form of global investment mania that attracts investor attention in a big way. In the late 1960s/early 1970s, there was a mania in mining stocks and then the 'nifty fifty' in the US. In the late 1970s, there was a mania in gold. In the second half of the 1980s, it was Japan. In the late 1990s, it was technology stocks.

Our view is that the next investment mania is likely to be focused on emerging markets and related themes. The emergence of the BRICs (Brazil, Russia, India and China), and China and India in particular, is the biggest economic displacement this decade. This has been a very positive force in the global economy, boosting growth while helping to keep inflation and interest rates down. But as is often the case, investors can end up pushing asset prices too far. So in thinking about what is the next investment mania to take hold, emerging markets, China, Asia and related plays such as commodities are ideal candidates.

This is arguably already underway. While all share markets have benefited from recent US monetary easing, Asian shares have risen far quicker from the August correction. And in part reflecting its Asian exposure, the Australian share market has, too, with resources leading the way. Asian and Australian shares have rebounded faster than US-dominated global shares.

Relative to global shares, Asian shares now appear to be back in a secular bull market. After booming during the 'Asian miracle' years, Asian shares spent a decade spinning their wheels. But while Asian shares have started to accelerate relative to global shares, the ratio (of outperformance) is well below peaks in the 1990s, suggesting it may have a long way to go. Asian share valuations are not as compelling as they were a few years ago and are, in fact, trading at a PE premium compared to global shares.

There are good reasons to believe this is sustainable. Firstly, Asian economies are now in far better shape than was the case during the 'Asian miracle' years. In contrast to the situation 10 years ago: current accounts are in surplus; foreign exchange reserves are huge; foreign debt has collapsed; inflation rates are low; Asian currencies are undervalued; and corporate gearing is low.

On top of this, there has also been a big improvement in government transparency, the availability of information, the prudential supervision of banks and in corporate governance. If anything, given Asia's current account surpluses and huge foreign exchange reserves, macro risk has now shifted away from Asia to the US which has been highlighted by the US sub-prime crisis.

This is the exact opposite of the situation a decade ago. In the second half of the 1990s, Asia was in trouble and the US was the place to be. Today, it is the other way around. In many ways the current environment is a bit like that of the early 1990s which saw a US downturn, lower US interest rates and a liquidity rush into Asia, which arguably helped start off the huge out-performance of Asian shares into the mid-1990s.

Stronger growth prospects

Secondly, Asia offers stronger growth prospects than developed countries which should result in higher earnings growth and see them trading on a higher PE ratio. Of course, the current run-up in Asian shares is dominated by China and India. Hong Kong is benefiting from the boom in Chinese shares and lower interest rates flowing from its US dollar peg.

There are several points to note. First, while valuations are stretched in both countries with Indian shares trading on a PE of 23 times and mainland China on a PE of 50 times, by historical standards this is not that extreme. Japanese shares peaked on a PE of 70 times in 1989 and the tech-heavy Nasdaq hit a PE of 160 in 2000.

Secondly, China and India offer the strongest earnings growth in Asia and so it is little wonder they trade on higher PEs compared to the rest of Asia. Finally, severe monetary tightening capable of really threatening their share markets seems a fair way off in both countries. Non-food inflation in China remains low at around one per cent and inflationary pressure has started to abate in India. This means that the strength in both these countries' share markets could have a way to go, notwithstanding periodic corrections.

The China/India theme is also likely to have a positive impact on the rest of Asia as it is helping to underpin intra-regional trade and attracts capital to the region.

The table provides a rough guide as to potential share market returns over the next few years. They are based on starting point dividend yields and assume share prices rise with nominal economic growth. While actual returns are likely to be wildly different, the reasonable dividend yields and stronger growth potential in Asia support the case for several years of out-performance from Asian shares (whether it becomes a mania or not).

The writer is head of investment strategy and chief economist, AMP Capital Investors



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