Asian investors search for stability amid uncertainty

Large amounts of liquidity in the financial system combined with the much expected ‘great rotation’ from bonds into equities may develop into a short-term bubble in the Asian high beta stockmarkets. This risk is driving some regional private banks to recommend cautious allocations to Asian equities, while wealthy clients are exploring more global investment opportunities.

“If this great rotation really starts, you could theoretically see a huge amount of money going into equities in a very short period of time, as there is so much cash out there at the moment” says Roger Bacon, head of managed investments Asia Pacific at Citi Private Bank.

This may lead to a very momentum-driven rally in Asian equity markets, which may go up 30 or 40 per cent, possibly generating a short-term bubble, believes Mr Bacon. “When we become more constructive on Asian equities, we will still be looking not to rush in, to try and do things methodically.”

Towards the end of last year, Citi Private Bank recommended clients reduce their underweight positions to global and Asian equities and selectively go slightly overweight, based on valuations and better economic outlook. At the same time, clients took money off the table within their large fixed income allocations, by reducing leverage and taking profits in areas such as Asian high yield, funding their equity allocations this way. Cash allocations of up to 40 per cent, larger than they have been for many years, remained stable.

But during the first months of 2013, negative macro developments across the globe, such as the Cyprus crisis and the threats emerging from North Korea, slowed flows into equity. “The catalyst for an increase in equity allocations may be simply an absence of more bad news,” states Mr Bacon.

Clients, who typically have Asian-biased portfolios, have been reluctant to allocate aggressively to Asian equities. However, they have gained significant exposure to performing markets such as Indonesia, the Philippines, or Thailand, and have selectively increased allocation to the disappointing Chinese equity market in the belief it will correct at some stage.

Flows have gone into the more defensive end of the equity spectrum, in dividend-focused funds or customised portfolios of global blue chip companies with solid balance sheets and good earnings power, with good valuations and pay-out ratios of 3-4 per cent.

There has been more interest than expected in European equities, notes Mr Bacon, particularly in blue chip companies with strong balance sheet and good dividend yields, whose valuations have suffered simply because of where these firms are based. Flows into US stocks have recently slowed, as they are not as cheap as they once were, although good companies’ balance sheets and economic fundamentals may draw more flows into US equities this year.

International opportunities in real estate, for example in the ‘superprime’ residential market in London or New York, or in private equity, continue to appeal to wealthy Asians.

“Clients remain pretty happy to allocate money to illiquid assets but they are asking for more control, for more transparency, and we are helping them identify individual deals they can invest in, rather than buying a pooled vehicle of multiple investments,” says Mr Bacon.

Global outlook

Wealthy investors tend to be tactical in Asia, states Adam Tejpaul, head of investments Asia at JP Morgan Private Bank. Because they have had lower allocations to China over the past couple of years, they have been looking for more international market opportunities, such as US real estate, which today is more core rather than distress-oriented. Distressed credit opportunities in Europe are also in demand.

“In the last couple of years, we have had success where we have seen a very specific market opportunity and have been able to tie with a manager we thought could access that  opportunity,” says Mr Tejpaul. In some cases, the manager was asked to launch a new fund, offering the bank some distribution exclusivity.

Today, he says, clients feel more comfortable with investing in equities, while at the same time they can no longer expect double digit returns on fixed income, given interest rates are so low and credit spreads have compressed significantly. But to buy risky assets, money is being taken from cash rather than fixed income. “The great rotation from fixed income to equities erroneously assumes the clients are fully invested, but they have significant allocations to cash.”

However, investors are getting prepared for a rise in interest rates by favouring shorter duration and more absolute return-oriented products. Bond managers with more flexibility in managing interest rate duration or their asset allocation are gaining popularity, says Mr Tejpaul.

JP Morgan recommends a full weighting to equities, with an overweight to the US and full position to China, where valuations are low. “Over the longer term the China play will pay out well,” states Mr Tejpaul.

Investors’ search for income in the equity space can be explained by the higher quality of high dividend stocks, which tend to outperform the broader market especially in times of greater volatility and uncertainty, and provide some stability to portfolios.

“The prices of some of those high dividend stocks will be pushed up much faster than other stocks, and this means that a rotation needs to happen within the equity space, at some point,” predicts Mr Tejpaul.

Although the focus is still on core, high quality stocks, clients’ portfolios have started to be rotated towards other areas, such as more growth-oriented companies, cyclicals or technology companies in the US, which may perform better in an improved economic environment, or more emerging brands in the mid cap space, which have been underinvested in over the past couple of years.

In Asia and emerging markets in general, investors have far higher allocations to cash than in developed markets, explains Olivier Pacton, head of HSBC private bank investment group, Asia-Pacific. Clients tend to hold a “barbell portfolio”, with real estate or private equity investments on one side and substantial cash on the other. Cash is kept in large quantities to face life’s uncertainties, as in some Asian economies the pension or healthcare systems are not as developed as in more mature countries. Investors also like to be able to take advantage of opportunities in real estate or private equity when they arise, which is how wealth was largely created in the region.

While people in North Asia, and particularly Hong Kong, hold a higher allocation to equities compared to South East Asia, across the board there is under-allocation to fixed income in which there is “constant, genuine interest,” notes Mr Pacton.

The main issue with holding fixed income is that in an environment where interest rates start rising, private clients, unlike institutions, are not all familiar with hedging long-dated interest rate risk or they may not have access to all the instruments required to hedge interest rate risk. They may be tempted to simply sell bonds. “One of the solutions would be to move clients from single securities into funds or discretionary programmes as managers should be able to manage this risk better,” says Mr Pacton.

Also, when interest rates start going up, clients’ attitude toward income paying strategies could change. The returns of 4-5 per cent generated by strategies such as dividend-paying equity funds are sustainable and clients are happy with them in a very low to risk-free rate environment, but this level of return becomes relatively less attractive if interest rates rise, says Mr Pacton. “And if the equity market starts rallying, investors would be more interested in higher yielding securities or growth stocks.”

Divergent performance

Looking forward, global economic growth will accelerate in the second half of the year, driven by the US economy and global monetary easing, according to Fan Cheuk Wan, head of research for Asia Pacific, private banking and wealth management at Credit Suisse. “The improving financial and systemic health of the economy and an over-abundance of liquidity will support global  reallocation from low-yielding assets into risky assets in the coming quarters,” she says.

The most attractive returns are expected to come from equities, but their performance will diverge. “One of the key drivers resulting in  divergent performance between emerging market equities versus developed equity markets is very favourable monetary policy supporting reflation of developed economies and earnings improvement in the developed markets, particularly the US and Japan,” explains Ms Fan.

Emerging markets have been enjoying more resilient economic growth, which means they have less urgency or room for manoeuvre for launching any extraordinary easing actions, also constrained by inflation pressures in the medium term.

At Credit Suisse, Japan and the US are the two high conviction strategic overweight bets in equity allocations. “We recommend investors overweight Japanese equities on the back of the aggressive monetary easing announced by the Bank of Japan, and the sharp depreciation of the yen which is going to support an earnings turnaround for Japanese exporters this year,” says Ms Fan.

Following news of a surprise contraction in the manufacturing sector in China, the 7.3 per cent one-day correction of the Nikkei 225 on 23 May seemed to be more driven by risk reduction and profit taking after the market’s massive 50 per cent rally since the beginning of the year,  she says, explaining that the ongoing quarterly reporting season in Japan reflects very positive earnings improvement momentum.

“This short-term tactical correction should offer entry opportunities for strategic investors to add exposure to Japanese equities,” states Ms Fan.

Foreign investors will need to hedge their currency position, though, as the yen is expected to depreciate further. “The Japan equity rally is not just a pure speculation and bubble, we do see fundamental support in this re-rating of the market,” she says.

While the overweight on US equity is based mainly on positive earnings upgrade momentum, in Asia the bank favours India, whose economy should benefit from weakened commodity prices, the country being  a large commodity importer. Also, the commitment of the Indian government to the fiscal reform programme will be a structural driver for market performance.

Other favoured countries are Thailand, expected to deliver the most attractive earnings growth in South East Asia, and Hong Kong – which remains a geared beneficiary of US quantitative easing because of its US dollar peg.

Weaker than expected Chinese economic growth in the first four months of the year introduces potential downside risk to the bank’s 2013 China real GDP growth forecast of 8.1 per cent. Credit Suisse remains neutral on the country, mainly because of the potential financial risk related to asset quality in the banking system in the medium to longer term, given the rapid credit growth reflected by the expansion in shadow banking.

In Europe, the bank is overweight Germany, whose economy is supported by more positive domestic and financial fundamentals versus other eurozone countries.

In fixed income, where it is strategically underweight, Credit Suisse is recommending selective exposure to emerging market bonds and sovereigns, plus high yield in developed markets, which are expected to deliver “relatively more attractive returns”.

Money flows in fixed income have been mainly into higher yield type products of late, confirms Brian Baker, CEO of Pimco Asia.

There has been demand in particular for yielding products, such as the firm’s diversified income strategy investing in corporate, high yield or emerging market bonds, or for the strategy looking for “high, safe income” in various regional opportunities. These may include Brazilian, Mexican or Australian government bonds or corporations in sectors expected to perform well, such as those linked to the US housing market, including home building retailers, material or appliance makers.

In a world with so many uncertainties – over the continued positive growth in the US, the eurozone’s survival, the success of Japan’s experimental policies, geopolitical risk in North Korea and Middle East, and concerns about the consequences of the Fed’s exit strategy from its loose monetary policy – an allocation to more stable assets like fixed income is bound to continue, says Mr Baker. Pimco’s view is that interest rates in the US, Europe and Japan will not rise over the next 12 or even 24 months.

Equity markets’ new highs have been driven by very accommodative monetary policies, which are pushing people into risky assets – although the leading sectors within stockmarkets are the more defensive ones – but economic fundamentals remain very weak. And in fixed income, spreads have compressed dramatically across the different sectors.

“The world is now coming to a crossroads,” states Mr Baker. Either central banks’ extraordinary policies will lead to sustainable economic growth, which would justify financial market valuations, or the effectiveness of those policies on financial markets assets will start to wane.

In the latter case, prices of financial assets will start coming down to reflect weak economic fundamentals, investors would take less risk and move to government bonds, and the riskiest assets such as equities would fall first.