I’m back in London this week and rather wishing I wasn’t. It’s not just the sudden cold and the Tube delays that make it such an unwelcome return. If there’s a single impression that I’d stress from my trip, it’s that Asia is far, far more upbeat about the economic outlook than the West.
Sure, Asia is always more dynamic. It’s growing faster and changing more quickly. But the gulf has never felt so wide. While Britain is locked into an austerity mindset, Asia is keen to lend, spend and invest. Investors out there laugh when I say that the British government hopes to have a high-speed London-Glasgow rail link by 2030. Their countries are building for the future now.
Overall, I’ve returned even more optimistic about Asia’s prospects than last time. But if there’s one thing that’s been worrying me in the last couple of weeks, it’s Ben Bernanke’s increasingly desperate efforts to jolt the US economy back on track. And what the unintended consequences could be in Asia.
Will QE2 lead to a bubble?
The US Federal Reserve’s latest round of quantitative easing (QE) caught me by surprise. I had thought that there was too much opposition within the Fed for it to happen before the middle of next year.
But the fact that Bernanke was prepared to force it through reinforces a point I’ve made before. If you look at his past speeches, it’s clear that he is willing to print money without limit to avoid any hint of deflation in the US. On the back of this, and the weak dollar over the last year, many people are arguing that debasing the dollar is now a policy goal.
I don’t believe that this is true. Instead I think the Fed is virtually indifferent to what happens to the dollar. And equally indifferent to the other consequences that this policy will have on the world. The goal is simply and only to boost money supply within the US and damn the consequences.
And those could be large. The one that most investors focus on is the possibility that higher liquidity and lower bond yields in the US push investors elsewhere in search of a return. If this stimulated productive investment in the US, it would be fine. But the risk is that it creates a bubble in other assets, such as emerging markets.
Some argue that this has already happened. They look at the strong performance of markets in Asia and elsewhere since the crisis (for example, the MSCI Asia ex Japan regional benchmark below) and say a rebound like this is a clear sign that markets are already overextended.
Why Asian markets are not yet expensive
But while I’d agree there is the risk of a bubble, I don’t see this yet. The table below shows four valuation measures for each market (price to earnings – p/e -, p/e based on forecast earnings, price/book and dividend yield) and their long-run averages.
These averages are taken over 15 years except for forecast p/es done over five years. Chinese A shares, Sri Lanka and Vietnam are much shorter at three to five years.
| P/E | Average | Est P/E | Average | |
|---|---|---|---|---|
| Asia ex Japan | 15.05 | 16.34 | 14.27 | 14.1 |
| China A shares | 21.96 | 24.55 | 19.75 | 19.15 |
| China HK listed | 14.95 | 14.27 | 14.18 | 14.26 |
| Hong Kong | 13.22 | 13.32 | 18.68 | 15.81 |
| India | 17.89 | 16.79 | 18.89 | 18.8 |
| Indonesia | 19.36 | 15.79 | 17.93 | 13.74 |
| Malaysia | 13.34 | 17.29 | 16.32 | 15.43 |
| Philippines | 18.54 | 17.9 | 17.53 | 14.97 |
| Singapore | 16.19 | 16.58 | 15.45 | 14.86 |
| South Korea | 10.85 | 14.54 | 10.84 | 11.8 |
| Sri Lanka | 22.53 | 17.7 | 26.95 | —- |
| Taiwan | 13.92 | 19.25 | 13.82 | 13.91 |
| Thailand | 14.55 | 12.44 | 14.25 | 11.12 |
| Vietnam | 11.97 | 13.06 | 11.6 | 12.56 |
| Japan | 15.51 | 70.08 | 15.5 | 32.28 |
| UK | 17.24 | 18.4 | 11.65 | 11.77 |
| US | 15.18 | 18.78 | 14.24 | 15.23 |
| P/B | Average | Dividend yield | Average | |
| Asia ex Japan | 2.05 | 1.83 | 2.19 | 2.4 |
| China A shares | 3.1 | 3.2 | 0.97 | 1.02 |
| China HK listed | 2.44 | 1.82 | 2.12 | 2.27 |
| Hong Kong | 1.73 | 1.48 | 2.36 | 3.52 |
| India | 3.27 | 2.98 | 1.16 | 1.13 |
| Indonesia | 4.64 | 2.56 | 2.17 | 2.02 |
| Malaysia | 2.39 | 1.87 | 3.22 | 2.92 |
| Philippines | 2.9 | 1.88 | 3.09 | 2.18 |
| Singapore | 1.86 | 1.75 | 2.75 | 2.66 |
| South Korea | 1.45 | 1.23 | 1.24 | 2.38 |
| Sri Lanka | 3.21 | 1.94 | 1.26 | 1.76 |
| Taiwan | 2.03 | 2.02 | 3.38 | 1 |
| Thailand | 2.3 | 2.08 | 3.38 | 2.76 |
| Vietnam | 2.68 | 2.83 | 1.93 | 1.99 |
| Japan | 1.12 | 2 | 2.01 | 0.98 |
| UK | 1.9 | 2.37 | 3.18 | 3.34 |
| US | 2.15 | 2.95 | 1.92 | 1.77 |
Source: Bloomberg, MSCI
As you can see, few of the measures are in what I would call bubble territory, although a few countries are looking more expensive.
Sri Lanka is clearly the priciest. Investors are betting on a rapid improvement in the economy following the end of the civil war. Now, I’m only just beginning to get to grips with this economy. But my feeling is that the market might have run a bit further than is justified by fundamentals.
Most markets are not far out of line with their long-run averages. However we’ve seen a substantial rerating in Indonesia as it returns to grace with foreign investors. The market continues to power upwards despite concerns elsewhere in the world. The chart below shows this.
If I were to pick a single candidate for a major bubble in the next few years it would be Indonesia. India, although not currently expensive relative to history, would be another. It seems everyone is buying the story that it’s a far better investment in every way than China.
Elsewhere, the Philippines is also perhaps notably more expensive than usual. As a small, illiquid market, I’d also say this has high bubble potential if it shows any signs of political progress. And Thailand has also seen a major improvement in sentiment. Foreign investors are convincing themselves that the violence in April and May marked the turning point. But generally, equities don’t look either cheap or expensive relative to history.
The only point that stands out is that the price/book (or price/net asset value) ratio is somewhat higher than usual for most markets. That’s true even where p/es are more in line with the past. This reflects improving profitability at many Asian companies (or an ability to earn more from their assets). This will need to be sustained to justify these valuations in the long run.
Income hunters pile into emerging market debt
The one area where I am getting slightly concerned is emerging market bonds. Over the past year or so, I’ve talked about these a number of times. In brief, the arguments in favour of a boom in emerging market debt were fourfold. First, a reassessment of the relative risks of these countries compared to the developed world; second, the attractive yields that many offer to income-seeking Westerners; third, the possibility of currency appreciation gains on bonds denominated in local currencies; and finally, the likelihood that emerging economies will continue to improve their inflation management just as Western central banks will tolerate higher inflation to inflate away their debt burdens.
The first three of those points has clearly been borne out. The chart below from UBS shows foreign holdings of bonds and shares for a sample of countries that report regular data. As you can see, equity holdings are still below their 2007 peak. But foreigners have flooded into emerging market debt, taking their holdings to a record for the short data history (and I would think probably an all-time high).
And many of these countries have seen the yields that they need to offer buyers of the bonds fall to new lows as a consequence. The table below shows the current yield on the ten-year government bond for each country versus the average over the last ten years for most. (Due to data limitations, the average is taken since 2003 for Indonesia, 2005 for China, 2006 for Vietnam and 2008 for Sri Lanka.)
| Current yield | Ten-year average | |
|---|---|---|
| China | 3.81 | 3.58 |
| Hong Kong | 2.43 | 4.01 |
| India | 8.025 | 7.382 |
| Indonesia | 7.425 | 11.16 |
| Malaysia | 3.91 | 4.06 |
| Philippines | 5.875 | 10.67 |
| Singapore | 2.13 | 3.01 |
| South Korea | 4.48 | 5.43 |
| Sri Lanka | 9.47 | 13.12 |
| Taiwan | 1.36 | 2.45 |
| Thailand | 3.52 | 4.53 |
| Vietnam | 11.51 | 10.44 |
| Japan | 1.07 | 1.4 |
| UK | 3.39 | 4.48 |
| US | 2.87 | 4.19 |
Source: Bloomberg
Many countries have seen a substantial fall in yields. These include again Indonesia, where the ten-year bond now yields 7.425% (see chart below). As far as I know that’s a record low – at least in the modern era.
The Philippines and Sri Lanka have also seen notable falls.
However, the last argument in favour of emerging market bonds is not yet currently holding true. Inflation is not behaving as well as we’d like. And that’s the source of one of my biggest concerns at present – driven again by the actions of the Fed.
The inflation outlook is turning sour
We’re all aware that the developed world has seen a steady decline in inflation since the early 1980s. Central banks wrongly took this as assurance that they’d finally perfected the management of the economy and that all would be smooth sailing from now on.
But the same has also been true in much of the emerging world. As the chart below from UBS shows, average inflation fell steady in EMs during the last decade, at least up until the commodity price spike in 2007-2008.
But now, investors are beginning to get worried. China’s consumer price index (CPI) is up 4.4% year on year. India’s wholesale price index (WPI) – which is more closely watched there than local CPI because it’s better constructed and covers more goods – is up 8.58%.
What’s driving this? Generally speaking, it’s food prices. The first chart from Capital Economics below shows China’s CPI and the CPI ex food and energy (“core CPI”). The second chart from UBS shows the average of food and core CPI for those countries that report the breakdown. As you can see in both, core prices have barely moved.
There has been quite a spike in many agricultural commodity prices over the past year, as the chart of the Reuters/Jeffries CRB Food Index below makes clear. Many goods have suffered supply disruptions, such as the droughts in Russia that led to a wheat export ban there.
Higher commodity prices are a big deal for emerging markets. Poorer people tend to spend a larger proportion of their income on food and energy. The CPI calculation is supposed to be based on a representative basket of goods. So the CPI for an emerging market will have a higher weighting to food than in the developed world. In short therefore higher food prices have a much bigger effect on inflation there than in the West.
And this is not just a statistical issue. Developed market consumers might grumble about the rising cost of breakfast. But for poor people in emerging markets, it’s a matter of whether they can feed a family or not.
So higher food prices are a major social and political threat that can easily lead to serious unrest. It tends to be underappreciated in the West that the cause of the protests in China in 1989 (which were not solely in Tiananmen Square, but all around the country) were partly driven by anger over soaring inflation.
So emerging market governments will try to act quickly to contain inflation if it seems to be getting out of hand. This doesn’t just involve raising interest rates. It could also mean subsidies for poorer consumers, price controls on key foodstuffs and utilities, bans on exporting key agricultural goods and stockpiles of key supplies to be distributed when prices spike.
The problem is contained – for now
The good news is that despite the headlines about China and a couple of other countries, we don’t yet have much evidence of a general spike in emerging market inflation. As the chart below shows, inflation in most countries is still below the average over the past decade. (Average for Sri Lanka is since 2005, Vietnam since 2006 and India since 2008 due to a data change.)
| Current | Ten-year average | |
|---|---|---|
| China | 4.4 | 2.1 |
| Hong Kong | 2.6 | 0.4 |
| India | 8.58 | 6.65 |
| Indonesia | 5.67 | 8.71 |
| Malaysia | 1.8 | 2.2 |
| Philippines | 2.8 | 5.3 |
| Singapore | 3.7 | 1.6 |
| South Korea | 4.1 | 3.2 |
| Sri Lanka | 6.6 | 11.6 |
| Taiwan | 0.56 | 0.96 |
| Thailand | 2.8 | 2.6 |
| Vietnam | 9.7 | 10.99 |
| Japan | -0.6 | -0.3 |
| UK | 3.2 | 2.1 |
| US | 1.2 | 2.4 |
Source: Bloomberg
Indeed, in some countries such as Indonesia that have seen rising inflation this year, the rate is showing some signs of dropping back again.
While in others such as Malaysia, inflation has so far remained well-behaved throughout.
Another key point is that the most serious food inflation that we’ve seen so far is confined to a few commodities. It also seems to a consequence of supply shocks. And as long as this continues, the effects should be limited. We would probably be looking at just a few countries that need to take action.
Most obviously, China has announced a number of measures in the last week targeted specifically at food prices, as well as a further tightening of monetary policy intended to stop inflation spreading beyond food. We can probably expect to see tighter policy and higher rates over the next few months.
India may also need to raise rates again and Korea seems to be a little behind the curve. Hong Kong’s biggest problem is rising property prices; the government introduced more new measures this weekend to try to cool the market. And Vietnam’s policymakers seem to be putting off necessary action until after the communist party congress in January. That’s probably because of political infighting. But generally, action should be limited.
The big risk lies with the Fed’s QE. If this increases speculation in commodities – as ultra-easy policy obviously did in late 2007 and early 2008 – then we may have a major inflation risk on our hands.
This would cause a great deal of pain in emerging markets. It would be a major political issue – if China’s trade surplus is an issue in America, then an irresponsible Fed causing rampant food inflation would be equally unpopular in emerging markets.
And it would probably be bad for markets. It would present a headwind for stocks. It would be exceptionally tricky for sectors such as utilities, oil refiners and producers of essential foodstuffs. These would almost certainly have to deal with government price controls.
And it would probably be especially awkward for emerging market debt. The gap between current rates and current inflation is already generally less than the gap between average rates and average inflation in recent years (see table below).
| Current | Ten-year average | |
|---|---|---|
| China | -0.59 | 1.48 |
| Hong Kong | -0.17 | 3.61 |
| India | -0.555 | 0.732 |
| Indonesia | 1.755 | 2.45 |
| Malaysia | 2.11 | 1.86 |
| Philippines | 3.075 | 5.37 |
| Singapore | -1.57 | 1.41 |
| South Korea | 0.38 | 2.23 |
| Sri Lanka | 2.87 | 1.52 |
| Taiwan | 0.8 | 1.49 |
| Thailand | 0.72 | 1.93 |
| Vietnam | 1.81 | -0.55 |
| Japan | 1.67 | 1.7 |
| UK | 0.19 | 2.38 |
| US | 1.67 | 1.79 |
Source: Bloomberg
If inflation were to rise sharply, interest from local investors (who are concerned about the real yield – ie after allowing for local inflation) would fall. That would leave the newly arrived foreign buyers (who are hunting yield and aren’t concerned about the local real yield) to support the market. I would be worried about EM debt in an atmosphere of rising inflation.
For now, I still think an inflation spike is unlikely. One comfort is that while commodity inflation is most damaging in EMs, 2007-2008 demonstrated that it is pretty unpopular in developed markets as well. And if we see another broad-based surge, I think the calls for curbs on speculation that we heard back then will grow stronger again. Even the Fed will find it hard to defend an excessively loose policy in that climate.
But it’s a risk that we need to keep an eye on. And it is a good reason to have a small allocation to inflation hedges such as gold in your portfolio, alongside more optimistic investments such as Asia.