Asia - Pacific: Surviving the Year of the Rooster
Andy Xie, Morgan Stanley (Hong Kong)
I have three ideas on businesses that investors shun and three ideas
on businesses that investors should embrace.
Pitfalls to avoid:
1) Overcapacity
Overcapacity in downstream industries, primarily in China, is coming
out to depress profit margins everywhere. The auto sector is a
well-known example. This industry may have twice as much capacity
as demand in China. One Taiwanese businessman told me that Eastern
China had added capacity for six million tons for formaldehyde
production but consumes two and a half million tons at present.
Examples like these are plentiful in construction materials,
electronics and components, chemicals and numerous light
manufacturing industries.
As most companies with excess capacities are supported by local
governments, they will keep producing regardless. The profit
squeeze in the downstream industries is likely to spread all over
the world. The news flow in this part of the global economy will
turn quite negative this year, in my view.
I would avoid downstream manufacturing completely in 2005.
2) Rmb speculation
An expected Chinese revaluation led the charge in the liquidity
surge into Asia last year. A final frenzy in Rmb speculation is
possible, especially around mid-2005 when the US economy might
disappoint the market. Overall, I believe that the sentiment
towards Rmb will cool in 2005. The sentiment may turn sharply when
China's overcapacity problem becomes headline news.
Any asset that benefited from the liquidity inflow last year is
vulnerable. The property sector in China/Hong Kong space (both
stocks and properties) could suffer. The negative spread between
Hibor and Libor at around 200 bps is likely the first speculative
phenomenon to disappear. When it does, Hong Kong's mortgage
interest rate could double.
I would avoid property-related investments in 2005.
3) Korea consumption
Korea's consumption has been quite weak but is showing signs of
bottoming out. Korea is considered a high beta economy - one that
rises and falls quickly. The market has jumped on the bottoming
signs and has been chasing the recovery story.
I believe that the market is making a mistake. The Korean economy,
in my view, has become a low beta economy. The coming recovery will
be surprisingly mild. The main reason is that Korea is no longer an
investment-driven economy and household leverage is already high to
accommodate a quick rise in credit.
The consumer sector grew rapidly on increasing debt leverage from a
low base in the last cycle. It overshot and came down when the
credit card bubble burst. While the worst of the credit card fiasco
is behind us, current household debt is at 60% of GDP and does not
have room for another quick buildup. When the previous consumption
cycle began in 1999, the household debt was at 40% of GDP.
I would be cautious on Korean consumption.
Strengths to embrace:
1) Balance sheet
Many economies in Asia have improved their balance sheets in this
cycle. They have leveraged into China's growth for income but have
kept down debt growth at home. Hong Kong, Korea, Singapore, Taiwan,
and Thailand have kept credit growth under 10% despite strong
economic growth in this cycle. During a similar liquidity boom 10
years ago, these economies grew credit by about 20% per annum.
Clearly, they have learnt the lesson from the 1997-98 financial
crises.
Strong balances will keep these economies steady as the global cycle
turns down. In the past, as soon as the global cycle turned, they
would experience credit events that would push the economies down.
The odds of significant credit events are, we believe, relatively
low in this cycle.
The investment implication from this development is that the banks
would be quite resilient in the down cycle. In the past, Asian
banks were leveraged plays on the Fed cycle. They will behave
differently this time, we believe.
The other implication is that the dividends are safer in this
cycle. Asian companies cut dividends during a down cycle due to
balance sheet pressure. This risk is much lower in this cycle.
2) Soft commodities
China had a relatively good harvest due to better incentives from
the price increase in 2003. However, imports of agricultural
products remained very strong. Industrialization, urbanization and
degradation of arable land due to over-farming suggest long-term
weakness in China's agricultural production, especially for land and
water-intensive products. The long-term trend of prices for
agricultural products looks strong.
It is difficult to capitalize on the rising prices for agricultural
products. The best approach is to buy farmland with good water
supply. Farmland prices vary greatly around the world, because
government subsidies have prevented global trade from equalizing the
prices. As the prices of agricultural products rise sufficiently
high to obviate the need for government support, farmland prices
should equalize.
The next best approach is to invest in the domestic demand of the
economies that are strong in agriculture. Brazil, Indonesia,
Russia and Thailand, for example, could benefit substantially from
this trend.
While this is mostly a long-term play, it should work in the short-
term also. As the global cycle turns down, the news flow from this
sector should remain quite upbeat. The industries and the economies
that benefit from this trend would show better results this year.
3) Energy
I am very bullish on coal but short-term bearish on oil. As
China's electricity generation capacity catches up with demand, the
country's energy consumption is shifting from oil to coal. China's
coal consumption could rise by 10% to 2.2 billion tons in 2005, in
my view. Domestic production is unlikely to catch up with demand.
Imports could rise by 50% or more (see `Oil vs. Coal', January 17,
2005).
I was very bullish on oil before. Three years ago, I recommended
oil as the best play on China's growth. This story is now known to
the market. Moreover, China's overheating has exaggerated its
demand in the short term, which the market interprets as part of the
structural trend. The long-term oil price is hovering around $40
per barrel. Considering that China's per capita income is just
about $1,300, its purchasing power is still limited and, therefore,
the upside for oil price is quite limited from hereon. Further, the
risk of a difficult landing of the Chinese economy could be quite
painful for oil.
The macro picture paints a difficult year of the Rooster for
investors. When growth rate is coming down and interest rate going
up, it is an uphill battle to make money. In my view, micro rather
than macro holds the key to profitable investments in 2005. |
