Setting Asia free from Western woes

Wealthy investors are eager to make fat returns from Asia’s rapidly growing economies. But the extreme sensitivity of Asian equity markets to every twist and turn of the eurozone crisis has left them scratching their heads over how to achieve this.

Asian markets collapsed during 2011 in tandem with European and US markets. The rapid and continuing recovery of prices in the region this year has only strengthened investors’ fears that the fortunes of Asian equities remain closely tied to share prices in developed Western nations. The question for wealth managers and their clients is how to achieve good returns in Asia that will not be abruptly erased if Western stockmarkets turn down again.

Wealth managers have stepped forward with solutions based on asset classes such as sovereign and investment-grade corporate bonds, and country plays that include southern Asian nations. For clients keen on keeping money in equities, they see potential in strong dividends and domestically-focused sectors.

These new stratagies are largely a response to customer pressure. “Finding assets that don’t correlate with European and US equities has definitely become important to clients over the last three years,” says Norman Villamin, Asia chief investment officer at Coutts.

But that demand can be a tall order. “We are living in a global village,” says Yonghao Pu, Asia-Pacific chief investment strategist for UBS Wealth Management. “When US, eurozone and UK equity markets went down last year it affected even Hong Kong. There was nowhere you could hide.”

Some Asian equity indices, including Hong Kong’s Hang Seng, fell even more sharply than eurozone indices in response to last year’s European troubles. Between late July and early October the FTSEurofirst 300 Index dropped 19.9 per cent, but the Hang Seng sank by 27.6 per cent over the same period. The two yardsticks then experienced sharp rises in the first two months of this year – followed by dips in early March. When it comes to US equities, the correlation between the S&P 500 is as high as 0.9 for some Asian indices.

To find Asian assets relatively uncorrelated with Western equities, wealth managers must first understand why so many Asian assets are so correlated. They see two reasons: interdependence in the real economy and interdependence in funding markets. Analysts say the trend towards correlation has been accentuated by increasing amounts of investment by funds financed by bank debt. As a result, Asian equity markets are indirectly dependent on the lending appetite of US, European and other international banks.

At moments of crisis, such as August 2011, banks have called in loans or increased short-term rates. This has prompted funds to sell assets to meet funding squeezes – particularly in the most liquid markets such as Hong Kong. “The Hong Kong equity market is seen by foreign investors as an ATM machine,” says Ronald Chan, head of Asian equities at Manulife Asset Management.

Heavy direct funding to Asian companies has further increased the interconnection. Leaving aside the local banks, Mr Villamin of Coutts estimates international banks have lent about $1,000bn to Asian businesses over the past two years. “Banks have been active lenders where there’s growth and they think they can make attractive returns,” he says, and in many cases, this means Asia rather than the West.

In addition to these financial linkages, the equity markets of China and other countries with export-focused economies are affected by prospects for Western economic growth. One way to mitigate these linkages is to invest in countries or sectors not highly dependent on foreign exports or financing.

“In last year’s equity markets, South Asia performed slightly better than other Asian regions,” says Mr Pu of UBS. “Malaysia and Indonesia did well because they don’t export so much to the West, and there are also fewer Western funds invested in their markets. For that reason, they didn’t experience a ‘risk-off’ funds outflow.”

Comparing Malaysia with India – whose market has performed particularly badly during recent global stockmarket tension – he points to “a crucial difference. Malaysia has a current account surplus, but India has a severe deficit,” which leaves India vulnerable to sudden outflows of overseas money.

Wealth managers say that despite China’s reliance on exports, there are growing opportunities for clients to invest in domestically-focused stocks as the government reorients its economy away from dependence on Western demand. As a Chinese domestic demand play, Arjuna Mahendran, Asia head of investment strategy at HSBC Private Bank, recommends construction equipment companies benefiting from the government-led infrastructure boom.

“Utilities, telecoms and other sectors relying on domestic consumption are good defensive sectors in Asia,” says Mr Pu of UBS. Within these, he regards companies dealing in consumer staples as particularly defensive.

Another play that shows relatively little correlation with global equities is to invest in the many Asian companies, in China and elsewhere, in which the state holds a stake – including telcoms and other utilities, banks and insurers. At the other end of the spectrum, says Mr Pu, are cyclical, export-focused sectors such as cement and other materials, or shipping and other transportation.

Some wealth managers see defensive potential for customers not just in consumer staples, but also in products and services that will benefit from Asia’s growing middle-class – allowing the companies to keep growing earnings regardless of a downturn in the West. Rahul Chadha, head of Asia-Pacific equities at Mirae Asset Global Investments, a Korean company managing $55bn, recommends education companies providing tuition for university entrance. A Chinese education company in Mirae’s portfolio is New Oriental Education.

Many of these defensive stocks feature in another decorrelation strategy: dividend yields. “When clients face a lot of capital risk in equities, they can skew their return profile towards dividends,” says Mr Villamin of Coutts.

He advocates utilities in general, and telecoms in particular. “In Asia many telecoms companies are either monopolies or oligopolies, which tend to be very cash-generative.” He adds to the list cash-rich gaming companies listed in Hong Kong, Singapore and Malaysia.

Manulife’s Mr Chan says investors can find stocks less sensitive to rapid global shifts by digging deeper beyond the large-cap companies that make up local indices, to invest in lesser known, less liquid small and mid-cap stocks not prone to large inflows and outflows of foreign money. He thinks the high correlations between Western indices such as the S&P 500 and Asian indices are misleading, because they do not take into account these smaller, less correlated companies.

“The trick here is that the overall market is a lot bigger than the index,” he says. The average correlation between the S&P 500 and the Hang Seng – made up of a maximum of 50 large-cap stocks – was 0.72 between 2001 and 2011. However, taking the 1,500 stocks listed in Hong Kong, Manulife calculates a correlation of only 0.26.

For investors addressing excessive correlation by picking shares little touched by other Western investors, a radical solution is to invest in small frontier markets. Vietnam’s Ho Chi Minh index has an average correlation with the S&P of 0.3. But Richard Cardiff, CEO of Coupland Cardiff Asset Management, an Asia specialist based in London and Singapore, is wary. “Vietnam, Sir Lanka, Pakistan and Bangladesh are all very attractive and exciting markets, but investors are taking on liquidity risk. We are prepared to do that for smaller funds, but not for our larger ones.”

Asian bonds used to be seen as illiquid too – but that is changing. “Following the credit crunch, governments realise export-driven growth is not necessarily going to work given the deleveraging in Europe and elsewhere,” says Mr Mahendran of HSBC. “So governments have used bonds to build the social and political infrastructure necessary for higher domestic consumption. That has also built a nice, stable yield curve, and companies are piggybacking on that – creating a rush of bond issuance in Asia.” Asia-Pacific corporate bond issuance, excluding Japan, Australia and New Zealand, rose by 39.5 per cent to $340bn equivalent in 2011, according to Dealogic.

Mr Villamin of Coutts says corporate bonds fit well with a growing desire among clients for “strategies based more on total return – largely because volatility in many markets has become so high”. Analysts say the high volatility across many global markets is connected to their high correlations – with investors prepared to pay more for ‘risk-on’ assets during periods of optimism, but suddenly prepared to pay much less during ‘risk-off’ periods of gloom.

Values in Asia’s growing high-yield bond market have correlated strongly with equity indices – falling sharply in August, for example. But Asian and other emerging market sovereigns have remained stable. JP Morgan’s index of emerging market government bonds denominated in local currencies shows a return of 11.2 per cent in the year to March – in contrast to falls in many Asian equity indices.

“Asia’s investment-grade corporate bonds are quite defensive – they only fell by 5 to 8 per cent in August-September 2011,” says Mr Mahendran of HSBC, who thinks prices will be supported by growing demand. “In many countries populations are greying – and this is tilting their preference in favour of bonds, because they offer steady income after retirement.”

However, Woong Park, head of Mirae Hong Kong, says low benchmark interest rates in many Asian countries means low yields for investment-grade bonds. This leaves him unenthusiastic about the asset class, in a region where “you can find many good companies offering a dividend yield above 5 per cent”.

Another decorrelation alternative, says Mr Villamin, is Asian absolute return strategies that take advantage of global deleveraging trends. He sees potential in relative value strategies, such as buying companies in software and other sectors not sensitive to funding squeezes, and shorting “deep cyclical companies, like steel, that are much more sensitive”. Mr Villamin concludes: “When credit is dear, the company that doesn’t require as much credit will have an advantage.”

Ivan Leung, Asia chief investment strategist at JP Morgan Private Bank, advocates private equity as a potentially less correlated strategy – particularly in the case of the Chinese personal consumption sector. “You’re able to access a market segment that you can’t easily invest in through listed equities. And as the evolution of the Chinese consumer is less correlated to other global risk factors, by definition, you’re getting something less correlated with liquid global markets.

“Only about 10 per cent of investable listed Chinese companies are in the consumer sector,” he adds.

Perhaps the most radical solution of all is learning to love the high volatility of Asian equities – and their high correlation with Western markets. “We’ve seen a rush back into emerging markets this year,” says Bill O’Neill, chief investment officer, Emea, at Merrill Lynch Wealth Management.

“If people want to add beta and volatility to their portfolios, one way to do it is through emerging markets, including Asia.”

Yonghao Pu, UBS Wealth Management

“We are living in a global village. When US, eurozone and UK equity markets went down last year it affected even Hong Kong. There was nowhere you could hide”

Woong Park, Mirae Asset Global Investments

“You can find many good companies offering a dividend yield above 5 per cent”

The average correlation between the S&P 500 and the Hang Seng – made up of a maximum of 50 large-cap stocks – was 0.72 between 2001 and 2011...

...but taking the 1,500 stocks listed in Hong Kong, Manulife calculates a correlation of only 0.26

Woong Park, Mirae Hong Kong