Asia 2007: A Lower Gear for Stocks
Asia 2007: A Lower Gear for Stocks
Following a tremendous second half performance in 2006 that sent many Asian equity markets to new highs, performance in 2007 is expected to be slightly more cautious, largely because of expectations for higher risks vs. returns and tightening liquidity trends. Valuations have risen, limiting upside, but Asian economies and corporate earnings growth will be driven by domestic consumption due to pent-up expenditure, the wealth effect from higher property prices, and rising wages.
The slowing U.S. economy is a concern but can be mitigated by the higher domestic and regional growth. Favored markets for 2007 are South Korea and Taiwan. We see greater risk in India, mainly due to high valuations. Japan is expected to continue to lag on valuations that are not compelling, and with the promise of rising interest rates. Here is a country-by-country outlook for 2007:
After posting 30% annualized gains between 2003 and 2005, the MSCI Japan Index has lagged major developed and emerging market stock benchmarks year-to-date, as, in our view, high valuations and slowing economic and EPS momentum limit upside. Looking ahead to 2007, S&P's Equity Strategy Group believes the lackluster Japanese equity performance is likely to continue, as Japanese GDP growth slows to 2.3% from our 2006 forecast of 2.5%, amid slowing domestic consumption and weaker exports.
High valuations exacerbate investor anxiety regarding a peak in the current Japanese economic cycle. The MSCI Japan Index trades at 17 times 2007 consensus-estimated EPS, a valuation premium to other developed markets, such as the U.S. and Europe, which trade at 14.3 times and 13 times estimated 2007 EPS, respectively.
In addition, despite the valuation premium, estimated consensus for 2007 MSCI Japan Index earnings growth is slightly lower than that for other developed markets.
While share ownership levels in Australia have moved to levels not seen since the mid-1980s, we believe the market is likely to remain correlated to resource prices. Given our expectation of stable commodities prices in 2007, we have a neutral stance on the S&P ASX 200 index.
There is talk of rising rates in Australia, but so far the Reserve Bank of Australia (RBA) has held official rates steady, and we suspect a hike may be put off on the prospect of slower global growth.
The view on China remains positive despite concerns that the stock market rises of more than 80% for the A-shares and 50% for the H-shares in 2006 were too exuberant. Reversion to mean would dictate a normalized performance in 2007.
We note, however, that for the A-shares, which remain largely a domestic-only equity market, 2006 represented the first year of gains following five years of consolidation (the 10% gain in 2003 was relatively minimal). In fact, despite the 80% gain this year, Shanghai A-shares are only 3.6% above the 2000 yearend level despite corporate EPS growth having achieved a five-year compound annual growth rate (CAGR) of 15%. As such, share ownership level remains historically low, and valuations are not demanding.
Interest in the A-shares, however, is mainly due to their impact on the performance of the H-shares. A rising A-share market is likely to pull H-share prices higher, although the reverse is not necessarily true, given the lower p-e ratio of H-shares (17 vs. 29). Hence, our preferred entry to the China market is through H-shares.
The positive sentiment on China should also benefit Hong Kong, but we believe investors may continue to prefer H-shares because of their better growth prospects and the potential for currency gains. Nonetheless, we expect the property sector, dominant in Hong Kong's stock index, to continue to perform well on pent-up demand for space.
Like China, India is seeing robust economic growth, and the country has enjoyed a prolonged bull run. For Indian equities, 2006 will mark the fourth consecutive year of gains.
In fact, the S&P CNX 50 index has grown at a five-year CAGR of 21%.
With the S&P CNX 50 trading at a relatively high p-e of 28, the main concern is that the risk vs. potential return has increased. While EPS growth is still attractive at over 17%, much of the good news is already reflected in the prices. As such, the view on Indian equities is more subdued.
Following a stellar performance in 2005, when the market moved up 54%, the South Korean market has underperformed in 2006, and the KOSPI index will probably end up where it started. However, a better performance in 2007 is expected, partly because of the lag in valuation, with the KOSPI trading at 12.5 times earnings, below the historical median of 15.1 times.
Although economic growth is expected to moderate to 4.5% in 2007, liquidity appears to be improving. Coupled with the relatively low valuation, that results in our view on South Korea being positive.
The Taiwan market, while relatively cheap on a p-e basis, has lagged mainly because of loss of significance to investors, given the nonexistent China links. The continued stance against China and the potential for cross-straits tension are leading to limited reinvestment within Taiwan. This, in turn, has curtailed economic growth, leading to a convergence to the 4% level.
We believe that the Taiwan market is a beneficiary of investor interest in cyclical issues, particularly technology stocks, and corporate earnings growth is relatively attractive at 18.8%. As such, we have a positive view on Taiwan.
Singapore and Malaysia
We are neutral on Singapore and Malaysia, mainly on valuation grounds. Although Singapore should continue to enjoy the impact of a positive wealth effect from the market and property price upswing, expected corporate earnings growth lags the region.
We believe that Singapore and Malaysian companies are seeing a greater proportion of growth derive from outside their domestic markets. Global investor sentiment for Malaysia remains weak and, with valuations that are not compelling, this is likely to continue.
Most of the regional markets are in a sweet spot with the prospect for continued global economic growth, softer oil prices leading to less cost pressure, and potentially lower interest rates. In this context, the main risk is a delay in interest rate cuts.
This could happen if crude prices head back up, leading to stubborn inflation. This would negatively affect investor sentiment and lower risk appetite, leading to an outflow of funds from Asia like that seen in May and June of 2006.
In addition, any risk to corporate earnings would hurt market valuations. If domestic consumption proves weaker than expected in Asia, and that leads to excess capacity, profit margins may decline. Also, risk may arise from reductions in capital spending by corporations. Uncertainty could lead some companies to lower planned expenditure, which in turn may dampen regional economic growth.
Ultimately, market valuations remain attractive. Regional markets have generally converged to around 15 times current earnings. Our preferences are premised on those markets we see as relatively cheaper given company earnings prospects and potential risks.
However, with the interest rate cycle peaking, cyclical issues tend to outperform, and this should augur well for markets with a higher portion of such stocks in their exchanges. We also anticipate that small-caps will perform well given their lower average valuations and investors' heightened risk appetite.