The Time for Reckoning December 2015 Victor Rodriguez (VR), Kenneth Akintewe (KA) and James Thom (JT) spoke on the final day of the Aberdeen 2016 Market Outlook roadshow which was held in Singapore on November 27. An annual event, the topic this year was ‘The Time for Reckoning’. With an expected rise in US interest rates later this month, our speakers discussed the challenges and the opportunities that monetary policy ‘normalisation’ will bring. Victor set aside his Asian Fixed Income role for the day to step in and help convey the views of the MultiAsset team. Here’s a summary of the key points made during their presentations, and the discussion which followed, in a hassle-free question-and-answer format. Do you expect a Fed interest rate rise in December? VR: Yes, we do. Nearly everyone does. The US economy is strengthening, the labour market looks more robust and the mention of a China-led global slowdown has receded. That said, there are still grounds for doubt – the under-employment rate is close to 10%, wage data is soft and household debt is high so consumers are sensitive to interest rates. Janet Yellen may have backed herself into a corner on her decision, but it will be the right one. Markets have been hanging on this for too long. What will the consequences be? VR: Expect more volatility. The effect of quantitative easing (QE) has been to give markets a false sense of security. We’ve lived with the idea of the ‘Greenspan Put’ for so many years, that is, the idea that with any sign of a slowdown, the central bank’s going to come to the aid of investors and stimulate markets. But now we have the ‘Yellen Call’. The Federal Reserve is very reluctant to stay zero-bound in terms of interest rates and, by normalising, everyone is having to ask what the real cost of money should be.

Ideally how would you be positioned and what are you avoiding? VR: Treasury yields will start to increase from here, so they’re not an asset class we want to be in. Inflation-linked bonds on the other hand are attractive, certainly from a valuation perspective. No one’s worried about inflation at the moment. Better-rated corporate bonds may provide some value. We like European and Japanese equities on a hedged basis as they will benefit from continued QE. The dollar will remain strong, although we’re unwinding some of our bets there particularly as bearishness toward Asian currencies looks overdone. From a fundamental perspective, next year looks better for value investors provided the link between risk and market prices is restored.

How will a US rate rise affect Emerging Markets? VR: We could see kneejerk outflows but if so it will be a last leg down. Emerging markets (EM) are much better positioned today, with the rebuilding of current account positions since the taper tantrum of 2013. Many countries are now in a position of surplus or narrower deficits. Of course the Chinese wobble in August, when it announced a change to its currency framework, rattled investors. But we see flows stabilising and in some cases foreign institutions, which account for a growing share of emerging market debt, are returning. Can Asia pursue a more accommodative policy in the face of Fed action? KA: If the Fed is raising rates it signals confidence in the US economy. On this line of thinking, global growth should stabilise too. Real rates in Asia remain high relative to the US, most noticeably in the case of India. The Reserve Bank of India has cut benchmark interest rates four times in the past 12 months. Even so, with rates at 6.75%, this leaves plenty of room for further cuts should the need arise. In other countries I wonder if cutting rates would have much effect. For example, in Southeast Asia, you can argue, the easing cycle is coming to an end. In Thailand, household borrowing is a constraint on demand.

“ Now we have the ‘Yellen Call’. The Federal Reserve is very reluctant to stay zero-bound in terms of interest rates and, by normalising, everyone is having to ask what the real cost of money should be.”

Are you anxious over China? KA: No, the only crisis in China is one of perception. Two things have happened: first China changed its currency framework, so investors mistook this for a devaluation; second, they made the erroneous link with an economy that has been slowing. On a real effective exchange rate basis the renminbi has been appreciating for years, as the country moves up the value chain. A 3% ‘devaluation’ of the currency against the dollar since mid-August is neither here nor there. True, policymakers handled the revaluation message badly (the IMF made more flexibility a pre-condition for Special Drawing Rights membership). But services, rather than exports, now account for more than half of China’s GDP and economic growth in the 6%-6.5% range is a reflection of improved quality. Reforms are moving in the right direction too. For example, we’ve just seen the liberalisation of deposit rates, which we had not expected to see for another two years or so.

Asia still outperforms 1 January 2015 to 30 November 2015 cross market performance

10% 0% -10% -20% -30%

LC Return

FX Return

Hong Kong

China (Onshore)

JACI Comp

JPM EMBI Global Div

India

Taiwan

Citi US Govt

China (Offshore)

S. Korea

HSBC ALBI (Overall)

Thailand

Citi WGBI

Singapore

Philippines

Indonesia

Poland

Malaysia

JPM GBI EM

Turkey

Brazil

-40%

Total Return (in USD)

Source: Bloomberg, 30 November 2015



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Forward price-to-earnings ratio for MSCI World versus MSCI Asia ex-Japan 18 16 14 12 10 8

MSCI Asia ex Japan

Nov 15

Nov 14

Nov 12

Nov 13

Nov 11

Nov 10

Nov 09

6 Nov 08

Where are you positioned for next year? KA: Well, anywhere we see volatility we see an opportunity. Poor sentiment is perversely making us more excited because that’s when markets become oversold. Let me cite two examples. In the Indonesian bond market, the yield on the 10-year sold off to about 9.5% and the currency fell to Rp14, 500 to the dollar – a once-in-a-decade opportunity. Both have since rallied. Similarly, in Malaysia, there’s been such a valuation adjustment that we’ve gone from an 11% underweight to the respective indices – in effect, having zero exposure earlier in the year – to about a 3% underweight today. We should be probably neutral by the end of this year. The market’s still cheap and if there are more Fed-induced wobbles we might even end up overweight.

Asian companies are cheap

Nov 07

Why are you so enthusiastic about India? KA: This is an economy that has embraced reform very publicly – and stuck to its guns. Reserve Bank of India governor Raghuram Rajan started off by targeting inflation and only more recently has he been comfortable easing policy. His credibility soared and now there’s a real possibility that lower interest rates are sustainable. Next year the introduction of the Bankruptcy Code should help address issues within the banking sector, such as nonperforming loans. The government has focused on streamlining bureaucracy and getting states to compete with each other for resources. Much of the processing for this is moving online. It’s a real revelation. Foreign direct investment is now growing at around 25% to 30% year-on-year. The rupee has been one of the best-performing EM currencies and the bond market has followed.

Nov 06

What have been the positive stories? KA: For the rest of Asia, there’s actually been some pretty decent performance. The likes of the Philippines, which is a domestically-driven economy, are less correlated to weakness in global demand. India is one of our favourite markets. It’s undergoing a massive economic and political transition, and that’s been driving the very strong performance of the Indian bond market. As for all the fears about China, it has been a top-performing Asian bond market. Volatility has been among the lowest. It’s one of our biggest over-weights. We play it in different ways: onshore bonds via the Qualified Foreign Institutional Investor scheme, currency forwards and also the dollar-denominated credit market.

“ Anywhere we see volatility we see an opportunity. Poor sentiment is perversely making us more excited because that’s when markets become oversold.”

Nov 05

What led EM and Asia bonds to do poorly if fundamentals are satisfactory? KA: The story in 2015 has been one of a strong dollar combined with capital outflows. Big commodity producing countries like Brazil or Russia have been in a fix for a while. The JPM GBI-EM index, a basket of local currency emerging market bonds (especially Latin American securities) has performed extremely badly. Within Asia it’s been a torrid period for Malaysia too, given its oil and gas reliance. Low-cost rivals like Vietnam are eating at its manufacturing competitiveness. Recent political developments have been messy and the bond market is over-reliant on foreigners. To some extent these developments overshadowed the good news in bond markets elsewhere.

MSCI World

Source: Bloomberg, MSCI, 30 November 2015

What’s the case for Asian equities? JT: Valuations always matter and the advantage of markets today is that, based on a forward price-to-earnings ratio, Asia is trading at a roughly 20% to 25% discount to global equities, that’s around 13 times earnings versus 17 times for the world index. On a trailing price-to-book basis, local markets are trading well below their 10-year average. So a compelling story in aggregate and the reason we’re quite excited. Obviously individual markets and sectors vary, some are more expensive than others, and it’s fair to say that India as a market is still a relatively expensive one, certainly in contrast to Singapore. The Philippines would be another. So you have to be selective, and that’s where our stockpicking approach comes in. We’ve been adding to stocks in China and Indonesia this year thanks to increased volatility.



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Where will demand come from? JT: That’s a fair question. Earnings growth is weak and we don’t expect that to change significantly within the next year. But it always comes down to how a company is doing. One trend we like is that of better capital management. Asian corporates are returning money to shareholders through better dividend pay-outs, led by the more developed markets (where growth rates and investment opportunities tend to be lower). In share buybacks, the same momentum is evident. For example, government cooling measures have hit the Singapore property sector in the past couple of years and developers have responded by handing back cash. The best example, however, is Samsung Electronics’ $10 billion buyback and further pledge to return 30% to 50% of their free cash flow over the next three years or so. They’ve got a net cash balance sheet and they’re continuing to invest in expansion. I think their capex budget this year will be a whopping $23 billion. So the picture in Asia is very different to the US, where companies are borrowing to improve return-onequity. Do you have any market preferences? JT: We do like India, but we always have done. It’s expensive but quality compensates for that. One development we like there is the opening up of the banking sector. The state-owned banks have about 70% to 75% market share but non-performing loans as a percentage of total loans are more than double that of the private sector lenders. Private sector banks also boast better balance sheets and faster loan and deposit growth. This spells one thing to us: the private sector will take market share, even if the sector as a whole slows (which is a possibility given how stricken some of the state-owned banks are). How about China? You always seem bearish. JT: It’s well known that we find China a challenging place to invest. We’ve been underweight there in our regional portfolios for a long time. As with India, the public sector, or SOEs, is at the heart of problems brought on by excessive gearing, over-capacity and slowing growth. In the services sector, which is where growth is booming, the private sector is better represented and taking market share. So in the insurance industry, hospitality, real estate, healthcare and transport, the private sector is increasing its share. To give one example, we’ve invested in Shanghai International Airport which has benefited from very strong growth in outbound tourism.

“ What are we doing differently? The answer is: very little. We are sticking to our process, which is all about identifying good quality companies and not paying too much for them. Over the long term those fundamentals will get reflected in the share price.”

Given your under-performance in 2015 and longer term, what are you going to do? JT: Performance has been poor and it hurts. One reason is that QE and unorthodox monetary policies have distorted markets and they no longer respond to corporate fundamentals. In recent years liquidity and sentiment have been more important in determining asset prices. That’s why we’re excited by next year when we will see a ‘normalisation’ of monetary policy. There may be some volatility in the short term, but over the course of the year we hope and expect the relationship between corporate fundamentals and share prices will be restored. What are we doing differently? The answer is: very little. We are sticking to our process, which is all about identifying good quality companies and not paying too much for them. Over the long term those fundamentals will get reflected in the share price.



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