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Inflation, reflation and transition
Three macro themes: Inflation, reflation and economic transition
Riding inflation: Real assets, rising rate beneficiary, pricing power
Plays on capex boom: Selected IT, hotel, media, machinery equipment and banks
Investment upside in China, Indonesia and Malaysia: Commodity, construction
Three important and interwoven macro trends underlie our investment themes for 2011: 1)
Inflation – food prices may stabilise in 2Q, but expanding domestic demand, ample liquidity
and positive output gaps indicate elevated inflation; 1) Reflation – abundant liquidity and low
real rates continue to push investors searching for growth, either in the US, when a cyclical
lift asserts itself, or in Asia, when inflation moderates; and 3) Transition – long-term growth
expectations are being adjusted across Asia ex-Japan (AXJ) markets, with focuses on
China’s transition toward consumption and the investment cycle in ASEAN and India.
We recommend the following ways to benefit from the macro themes, in order of preference:
Riding on higher inflation: Our analysis of a similar period of rising inflation in Asia
and reflation in the US in 1993, suggests three types of sectors tend to perform well: 1)
inflation-hedged real assets (oil, coal, property, etc.); 2) beneficiaries of rising interest
rate (insurers); and 3) companies with strong pricing power (airlines, hotels, landlords,
high-end or branded retailers, etc.). By contrast, autos tend to underperform.
Capex boom beneficiaries: This is an overlooked reflation theme. AXJ capex only
staged a below-trend 10% rebound last year. We believe the outlook is favourable, as
profits are up, confidence high, corporate balance sheets strong, capacity tight and
interest rates low. We like select media, hotel, equipment, bank and tech names.
Government spending plays: China’s investment growth typically accelerates in the
first year of a new Five-Year Plan, supporting upside for select materials, construction
and equipment producers. Delayed reforms and tight liquidity in India lead us to prefer
cement and construction names in Indonesia and Malaysia as investment plays.
We construct three stock baskets (see page 4 for details) to benefit from these themes.
Executive Summary and Three Stock Baskets
Three important and interwoven macro trends underlie our investment themes:
Lingering inflation risk: Expanding Asia ex-Japan domestic demand, still loose
monetary policy, and positive output gaps inevitably invite inflation. Concerns on a
rise of generalised inflation and behind-the-curve tightening may linger this year.
However, tightening measures are likely front-end loaded as cyclical food price
increases should stabilise in 2Q.
Continued reflation in the West: Abnormally low real rates, quantitative easing
and fiscal stimulus provide potential upside to growth. With abundant liquidity,
investors are searching for growth, either in the US, when a cyclical lift asserts
itself, or in Asia, when inflation concerns abate (likely in the middle of the year).
Corporate capex tends to be boosted amid a reflationary environment.
Economic transition: China is rebalancing its economy toward consumption-led
growth, while ASEAN and India are reviving their investment impetus. That said,
we see upside to China’s FAI growth in the first year of a new Five-Year Plan (the
country’s 12th). On the other hand, we think that India may have a high risk in
delivering infrastructure investment, while Indonesia and Malaysia look set to kickstart
their investment cycles.
We recommend having exposure to these macro trends through three investment
themes, in order of preference:
Riding the inflation wave: Our analysis of the 1993 reflation experience suggests
that Hong Kong and Taiwan tend to do well amid liquidity-driven inflation. Three
sectors, in our view, should perform well: 1) real assets – we include in the below
basket Indian and Thai oil stocks as exposure to a strengthened US economy and
oil prices; Chinese coal names could benefit from favourable supply and demand
dynamics despite the short-term price cap; Chinese property on its cheap
valuations; 2) rising rate beneficiaries – we include Taiwanese insurers; and 3)
companies with pricing power – we include airlines, Hong Kong landlords, Chinese
luxury department stores and a Singapore upstream commodity producer.
Beneficiaries of corporate capex boom: Capex is a less-recognised reflation
theme. Asia ex-Japan corporate capex only staged a below-trend 10% rebound
last year. With low rates, high confidence, rising profits and strong balance sheets,
corporates are pressed to increase capex or M&A as capacity tightens and costs
rise. Selective IT services, media, hotels, machinery equipment and banks offer
high exposure to rising corporate spending. In China, strong wage growth pushes
corporates toward more automation. Drivers such as technological progress,
domestic economic scale and increasing global competitiveness also enable
Chinese equipment producers to seek overseas export opportunities.
Plays on government upside surprise: Investors’ long-term growth expectations
for China are being adjusted down as the country is in the process of economic
transition, while expectations for ASEAN and India are increasing. However, we
see investment opportunities in basic materials and construction in China as its FAI
could pose a positive surprise in the first year of a new Five-Year Plan. Cautious
investment sentiment has depressed some of these stocks’ valuations. We are also
positive on the investment cycle in Indonesia and Malaysia. By contrast, we would
be cautious on India’s infrastructure investment on potential execution
disappointment. In our view, cement and construction stocks in Indonesia and
Malaysia offer best exposure to the cycle on attractive valuations.
We construct three stock baskets as potential exposure to the above three macro
themes: Inflation, reflation and transition. See the following tables for stock names and
valuation details. More analysis on each theme and stocks are in the text.
Macro Themes: Inflation, Reflation and
Transition
We have bullish views on Asian equities, but believe the risk is heavily shaped by three
macro-economic themes: Inflation, reflation and economic transition. These three
macro themes also underlie our 2011 investment themes, which are centred on inflation
implications for consumers and sectors, corporate capex beneficiaries and government
spending in Asia.
Inflation: The centre of growth gravity is shifting to emerging markets, as global
rebalancing progresses. However, inflation is quickly rising as a major threat for
Asia, fuelled by a rapid run-up in commodity prices amid this reflationary
environment. China has moved to curb the inflation threat gradually, while other
policy markets elsewhere in Asia ex-Japan are perceived to be more sanguine and
may have been behind the curve. Moderate rate tightening so far is partly due to
the uncertainty of the recovery trajectories in the developed markets (DM). But
DMs’ growth acceleration, particularly in the US, could pose upside risk to higher
inflation in Asia ex-Japan (AXJ). Most of the rising inflation in AXJ so far is
dominated by food prices (mainly in vegetables); however, whether a higher food
price morphs into a rise in general inflation is a major tail risk to Asia.
Reflation: It is clear there is too much debt in the developed world, particularly by
consumers, driving the recent US recession (from December 2007 to June 2009
according to the National Bureau of Economic Research). There has been a great
swap occurring between consumers and governments, with governments
expanding their balance sheets aggressively by assuming more debt, and central
banks keeping policy rates at record lows. As a result, our economists do not
expect a double-dip in the US or the Eurozone (see “Global outlook: Tug of War” in
December 2010), where abundant liquidity and low rates have given the
economies a cyclical lift, reflected in recent better-than-expected macro data. We
believe abundant liquidity and low real rates will continue to lead investors
searching for growth, either in the US when a cyclical lift asserts itself or in Asia
when inflation moderates and policy tightening risks abate. Asset prices have
climbed in this environment, but associated policy risks also escalated. Corporate
capex is another overlooked area that should also be boosted under reflationary
stimulus.
Transition: By contrast, Asian governments are striving to rebalance their
economies toward domestic demand, through consumption (in China) or
investment (in ASEAN and India). Low debt levels in Asia ex-Japan and healthy
balance sheets for both consumers and corporates in the region point to a stronger
growth prospect. Long-term growth expectations, however, are in the process of
(upward or downward) adjustment across Asia ex-Japan markets as a result. A
consumption-led growth inevitably means slower long-term growth ahead, while the
beginning of the investment cycle tends to accelerate economic growth. That said,
during this transition period for Asia ex-Japan markets, we still see cyclical upside
risks in China’s investment growth due to the start of the new 12th Five-Year Plan,
but downside risks in ASEAN and India due to execution risks and tight liquidity.
In the following sub-sections, we look at the three macro themes and their implications
in more detail.
Inflation: Cyclical drivers may fade, but concern will stay
The spectre of inflation continues to plague equity markets. Investors’ concerns are
primarily centred on three markets, China, India and Indonesia, all of which have seen
surging food prices in recent months.
Our conclusion is that CPI may start to moderate for the three countries in 2Q2011 as
the impact of near-term poor weather fades. We believe that moderating headline CPI
should give markets a temporary boost. However, inflation levels should stay elevated
relative to 2009/10 levels, and concerns about higher generalised inflation will likely
stay, in our view, due to other medium-term and structural drivers. Five drivers to
inflation are:
Supply-side disruptions (short-term cyclical factors): Extreme weather conditions
around the world cause supply-side shortage on food (heavy rains in India and
Indonesia, and snow in China).
Improving US growth outlook (medium-term cyclical factors): Recently improving
macro data in the US has driven the oil price to around USD91/bbl, posing
incremental risk to higher inflation in Asia. However, we believe the impact will be
of limited duration as the West still has a large negative output gap, which is
deflationary.
Easy liquidity conditions (medium-term cyclical factors): While policy rates
remain low across Asia, Chinese policy makers have started tightening and money
growth in China is moderating.
Positive output gaps (medium-term cyclical factors): AXJ domestic demand
continue to expand, while output gaps across most markets are turning positive, in
our estimates. Above-trend growth by definition will lead to higher inflation until
monetary policy moves toward restrictive levels.
Higher income and improving diet in Asia (structural driver) Strong emerging
market income growth is leading to a rapid improvement in diet, reflected in strong
demand for fresh vegetables, meat, dairy, and branded foods.
1) Short-term cyclical driver: A weather-related food crunch
Investors’ focus is centred on India, Indonesia and China (and to some extent, on
Korea) where food CPI has surged 12-18% y-y. There are different features in this cycle
of inflation. Most inflation in these three markets is caused by poor weather conditions
(heavy rains and snow), with price spikes dominated by vegetables (onions, tomatoes,
and cauliflower) and spices (such as chili). On the other hand, the price increases for
meat and poultry are in line with overall food inflation. Some of the food items that have
had extreme price spikes are:
India: Vegetables (59% y-y in December 2010), condiments & spices (38% y-y)
and chicken (34% y-y).
Indonesia: Spices (49% y-y in December 2010), cereal, cassava & related
products (27% y-y), and vegetables (20% y-y).
China: Vegetables (21% y-y in November 2010) and eggs (18% y-y).
Despite the rising food prices, the good news is that vegetable crops are harvested at
frequent intervals. Barring continued extreme weather conditions, we feel it is
reasonable to assume that vegetable food inflation should moderate by March/April
given vegetables’ much shorter crop duration, driving down food inflation by spring.
Indeed, China’s frequent retail agriculture products and vegetables surveyed by the
National Bureau of Statistics already showed sequential declines in December 2010 (for
instance, eggs are down 1.2% m-m).
The bottom line is that while the level of food prices may stay high longer, the rate of
food price increases may slow in the coming months, due to a high base effect and
abating cyclical factors. In the coming few months, investors may shift their focus to
search for signs of inflation peaking.
We believe China may see earlier relief in food prices and headline inflation, boosting
equity market performance. At a macro level, the Input Prices Index of PMI is a good
indicator for future inflation direction. While one month doesn't make a trend, the HSBC
PMI Input Prices for China may have peaked, with December 2010 down 8.5 points
sequentially to 72.3. If this downward trend continues in January, we should expect
moderation in China’s CPI.
2) The 1993-94 Experience – Inflation in Asia and reflation in the US
While short-term weather issues should soon fade, other inflation drivers will likely stay
longer – such as ample excess global liquidity. Our economist believes the US Federal
Reserve will keep monetary policy loose and not raise rates until 4Q12 (see “North
America Outlook: No Quick Fix” in December 2010).
In 1993 there was a similar period of rising inflation in Asia and reflation in the US to
what we are experiencing now. Due to the recession in the US from July 1990 to March
1991, the Fed cut rates from 8.25% in June 1990 to 3.00% in September 1992, and
kept the rates at trough levels for 17 months until February 1994. The inflation pressure
began to intensify in the middle of 1993 and did not peak until August 1994. From the
historical performance in 1993, it is clear that during the initial period of rising inflation,
Asian equities performed well. However, a continued rise of generalised inflation,
coupled with the monetary tightening by the Fed eventually caused a correction in
1994.
At a sector level, the companies that possess the following features performed well in
1993 when inflation was rising:
Real assets as a hedge against potentially higher inflation: Commodities
(particularly coal) and real estate sectors were up 116% and 91% in 2H93,
compared to Asia ex-Japan up 60% for the same period.
Beneficiaries of rising interest rates: Insurers rallied 90% during the period.
Companies that have strong pricing power: technology (up 189% in 2H93) and
consumer retailers (up 87%) were also outperforming.
On the other hand, consumer discretionary, mainly autos, were the major victims,
underperforming the market by 32% in 2H93, as rising inflation and interest rates
undermined consumers’ purchasing power.
While today’s reflation and inflation scenario is similar to the 1993 experience, there are
a few differences:
North Asia last year had not experienced a significant rally before facing this
inflation pressure. By contrast, ASEAN and India had better performance in 2010
and are trading at a premium to Asia ex-Japan overall. Even if the monetary
policies in ASEAN and India have not turned restrictive, rising inflation can pose a
greater threat to the markets, in our opinion.
In Asia, the inflation pressure so far has been concentrated in food, particularly in
vegetable prices. Whether vegetable price-driven inflation leads to a wider pick up
in inflation expectations and results in generalised rise in CPI, is something that will
have to be watched closely. A generalized rise in CPI should lead to more
aggressive tightening, which would be negative for equities.
In 1993, the combined weights of China and India accounted for less than 10% of
MSCI AXJ, while Hong Kong, Korea, Taiwan, Singapore and Thailand were the
major markets in the regional index. By contrast, China and India, combined,
account for a 36% weight of MSCI Asia ex-Japan today, and China’s growth
outlook and policy measures clearly have a far more influential impact than before.
3) The oil risk
If growth in the US continues to accelerate this year, commodity prices – particularly oil
– could become a major headwind for growth in Asia, as higher oil prices would lift
headline inflation, and prompt more policy tightening. With relatively high weights of oil
and fuel related items in CPI, Malaysia, India, Thailand and Indonesia are more
sensitive to domestic fuel price spikes.
However, these countries also manage their domestic fuel prices actively, while Korea,
Hong Kong, Singapore and Taiwan follow a floating fuel price mechanism, which mark
their domestic gas price to the market regularly. The consequence of domestic oil price
intervention is high levels of subsidy burden in Indonesia, Malaysia, and India.
The bottom line is that if the oil price rises and is sustained above USD100/bbl, India,
Indonesia and China would all probably see incremental pressure in their headline CPI,
given their already high inflation levels.
4) Structural driver – rising income and demand in Asia
Rising Asia ex-Japan consumer spending power is a secular trend in Asia, particularly
in the three major emerging markets – China, India and Indonesia. The trend of rising
consumer demand in Asia is intact (as we have analysed in our report last year
“Thematic Strategy: Tipping points for CHII consumer” dated 9 September 2010). To
recap, in the report we noted that we expect Asia ex-Japan consumption, particularly in
China, India and Indonesia (CHII) to continue to boom, driven by three structural
factors:
The rise of the middle class and higher income to drive consumer spending;
Continued urbanisation to drive consumption upgrades;
Supportive policy measures to drive lower savings ratios and higher leverage.
Rising wage growth tends to lead to structurally higher inflation, especially when wage
growth is higher than nominal GDP growth. A lot of attention was focused on China’s
accelerating labour wage growth in late 2009 and early 2010, partly due to labour
shortages in the costal areas. Indeed, some economists have attributed this
accelerating growth to the approach of a Lewisian turning point at which labour
shortages and wage increases occur. Arthur Lewis won a Nobel Prize for arguing in a
1954 paper that a developing country with “surplus” agricultural labour could grow its
industrial sector for years without wage inflation as it absorbs that surplus.
While it is debatable whether there is a labour shortage threat in China, it is clear that
labour supply growth in China is firmly on a decelerating trend. A tighter labour supply
would lead to faster wage growth. Japan’s wage and labour supply data (from 1965-
2009) demonstrates this point. In Japan, decelerating labour supply growth tends to
lead to higher-than-nominal-GDP labour wage growth, lifting household income to GDP
ratios and consumer purchasing power.
The causal relation is also true in China. Labour supply growth in China has
decelerated from 1% in 2004 to 0.7% in 2009. The United Nation Population Division
forecasts a further deceleration in labour growth to 0.5% during 2011-15. The chart
below shows that China’s negative gap between wage and nominal GDP growth has
narrowed since 2004. Wage growth in 2009 for the first time significantly outstripped
nominal GDP growth. We expect a trend of faster wage growth in China to persist.
Despite these secular drivers, the major cyclical headwinds to consumer spending
growth this year include elevated inflation, the withdrawal of selective government
stimuli (auto sales tax reductions) and a high base in 2010.
Rising inflation would erode consumers’ purchasing power and lead to slower real
consumer spending growth. Our economists forecast a moderate increase in inflation
across most Asia ex-Japan markets, with China and Hong Kong likely experiencing 1.1-
1.3ppt higher CPI in 2011. There could be further upside inflation risks for China, India
and Indonesia, as a result of rising food prices and the aftermath of ultra loose
monetary policies in 2009.
Reflation: Corporate capex will be boosted further
It is well known that reflationary policies tend to stimulate asset prices. It is less
recognised that corporate spending should also be boosted, in our view, under
aggressive fiscal stimulus and loose monetary policies. Furthermore, corporate capex
plays typically carry less policy risks than asset price plays, especially when
governments across Asia have escalated their tightening focus on property.
Non-financial corporates were at the centre of the recession a decade ago in the
developed world, but in the recent recession, the financials and households were at the
centre. The downturn, of course, still hit non-financial businesses. However, the
corporate sector has staged a V-shaped profit rebound amidst the lacklustre GDP
recovery in the developed world. Indeed, corporate fixed investment spending growth in
the US turned positive in 2Q10 and rose 7% y-y in 3Q10. That said, in terms of
investment to GDP ratio, the level of investment in the corporate sector is still well
below trend (see charts below).
A year ago we highlighted the upside potential for US capex spending, with an
investment focus on US technology spending recovery (“Thematic Strategy – A further
upswing for tech” dated 12 November 2009). US corporate tech spending registered a
stellar rebound since 1Q10, rising 11-13% y-y. The major beneficiary has been Indian
IT services companies, which rallied 33% in 2010 (compared to the MSCI India of 15%
gain).
The picture of Asian corporate capex spending is similar. Asian capex slumped 7% y-y
in 2009, compared to an increase of 21-22% in 2007/08. There was a V-shaped capex
recovery in 2010; however, the rebound was just 11%, with the capex-to-sales ratio still
low at 11% in 2010. Asian corporates are not unfamiliar with cutting capex. Following
the Asian and TMT crises, Asian companies showed persistent capex discipline,
thereby helping restore balance sheets and drive high profitability.
However, looking ahead, we believe corporate capex globally will begin to pick up
strongly, on buoyant confidence, tight capacity utilisation, high levels of cash in balance
sheets and low leverage ratios. In the US, the recovery of corporate capex should
broaden to other categories, particularly to spending on equipment. With a sharp slump
in equipment spending growth in the US during the recession (down 30% in both 2Q
and 3Q09), the equipment investment to GDP ratio collapsed. The recovery of the
equipment spending has just begun in the US and should continue.
Except for the Taiwan tech sector, capex spending growth in 2010 was well below trend
across Asia ex-Japan markets. Korea, Japan, Singapore and Indonesia still registered
negative capex growth last year, compared to the double digit trend growth rates during
2006-08. Among cyclical sectors, energy and industrial companies across markets have
reduced their capex aggressively, even in 2010 when the global recovery began to gain
some foothold.
Cash in corporate balance sheets in most Asian markets has been near or at record
highs for the past 16 years. The ratio of free cash flow (FCF) as a percentage of assets
stands at 2.2% in 2010 for Asia ex-Japan, close to the record high of 2.8% in 2003
when SARS hit most Asian markets. The ratios for Hong Kong and Malaysia jumped to
a record high in 2010, providing sufficient ammunition for capex spending or M&A
activities.
Another driver to rising corporate capex is increasing capacity constraints. As industrial
growth remains strong in most markets, output gaps in most markets are turning
positive, on our estimates, driving up capacity utilisation rates. Together with low capex
over the last 2-3 years, the need for capacity expansion is pressing. The investment
implications are centred on the industrials sector, selective materials, and technology
stocks. We will analyse these implications in more detail in later sections.
Another important implication is that we believe M&A activities could pick up
significantly in 2011. There are four reasons for this:
Corporate cash level is high, as we just highlighted, and leverage is low, with Asia
ex-Japan net debt to equity ratio at a record low 25% in 2010.
Valuations are at neutral levels, with trailing P/BV for MSCI AXJ and MSCI AXJ
Small Cap at 2.1x and 1.5x, respectively, which are close to their long-term
averages. The average M&A deal premium in Asia ex-Japan is still low at 14%,
down from 21% in 2007 and 2008. Given concerns on rising costs, we suspect that
companies will increasingly consider expansion through inorganic growth via
M&As, rather than organic growth, which is much slower.
M&A volume tends to lag the equity market cycle, as corporate confidence
recovers gradually. Current levels of M&A activity is still low, when measured as a
proportion of market cap (19% in 2010, compared to the peak of 39% in 2008).
Improving equity market performance is a lead indicator for M&A, as the chart
below shows.
Cross-border M&A activity in Asia should increase, as companies are looking to
access overseas end markets, build a regional platform or secure resources. The
recent acquisition of Kim Eng by Maybank is an example, as the bank would seek
to transform itself into a leading stockbroker in the ASEAN region.
Several companies have hinted their intent to conduct inorganic growth in the nearterm,
including, for example, Shinsegae (004170 KS; BUY; CP: KRW572,000), Yuanta
FHC (2885 TT; REDUCE; CP: TWD22.40), PetroChina (857 HK; BUY; CP: HKD10.52)
and Indorama Ventures (IVL TH; Not rated; CP: THB41.75).
Transition: Government’s balance between structural
adjustment and fiscal retrenchment
Governments across Asia ex-Japan markets are striving to achieve a balance between
structural adjustment and fiscal retrenchment. However, probabilities of upside
surprises in government-led investments still exist, in our view. We conclude that there
could be upside to the investment cycles in China, Indonesia and Malaysia. Our
analysis is centred on governments’ aims and constraints to identify potential areas of
upside surprises from two perspectives:
Structural economic adjustments;
Headwinds from fiscal retrenchment and monetary tightening.
One of the important long-term objectives for most Asian governments is to rebalance
their economies away from a heavily export-dependent growth model toward a
consumption and domestic demand-driven growth. On the other hand, Asian
governments (particularly in China) have been embarking on gradual de-leveraging
since early 2010, reducing the amount of their debt used to boost growth during the
recent global credit crisis by withdrawing fiscal stimulus, controlling credit quotas and
tightening monetary policies. Investment and infrastructure-related industries, as a
result of this governmental tightening, have underperformed in 2010 on cautious growth
expectations. Most of China and India materials, capital goods (infrastructure
construction/ clean energy related stocks) and real estate stocks were underperforming.
We believe the government investment theme will continue to face headwinds from
fiscal and monetary tightening in 2011, especially when the output gap is turning
positive on our estimates, and inflation risk is rising across Asian markets. That said, we
believe there are still selective money-making investment and infrastructure themes,
such as infrastructure build-up in Indonesia and manufacturing upgrade and social
housing in China.
1) Structural economic adjustment with a different focus
The export growth model adopted by Asian economies is being challenged. With
demand growth from developed economies likely to remain tepid, the need to rebalance
Asia’s growth engine toward domestic demand is well recognised. Since 2008, policy
makers have relied on the easier path of boosting domestic demand through ultra-loose
monetary policy and aggressive fiscal expansion.
Asia’s policy makers will continue to face the challenge of boosting domestic demand
on a sustainable basis, in our view. Depending on their development phase and the
structure of their economies, Asian governments have different areas to focus their
rebalancing on. For India, Indonesia, Thailand and the central and western part of
China, the need for further infrastructure build-up is clear, given their low urbanisation
ratios (see the chart above) and continuous migration of the rural population to urban
areas. From Japan’s experience we can see that before the urbanisation ratio reaches
55% fixed investment growth tends to stay at high levels, lifting investment-to-GDP
ratios. On the other hand, China’s overall investment share in GDP is already at high
levels and it is difficult to envisage the ratio getting much higher. We expect moderating
investment growth ahead in China.
On the fixed investment front, our economists forecast that six Asian markets are set to
have above-trend growth: India, Indonesia, Thailand, Malaysia, Taiwan and Korea (see
the chart below). Among Asian markets, as we’ve highlighted, three countries – China,
India and Indonesia – are expected to lead the domestic demand growth in the region.
Our economists expect both India and Indonesia to see above-trend and accelerating
fixed investment growth – 14%/15% in India for FY11/12 and 8%/10% in Indonesia for
2011/12. Growing urbanisation of the two countries and the governments’ commitments
to improve infrastructure facilitates should drive higher growth rates.
It is worth highlighting the different focuses of the three countries, given their size
(about 80% of the region’s GDP in 2010, on a PPP basis) and high investment growth
rates.
China: Given the already high investment to GDP ratio of 50% (compared to 36%
for the BRICs overall and 15% for the G7 developed countries), the aim of the
policy measures is no longer to boost investment further. Our economist forecasts
fixed investment growth to decelerate to 18% in 2011 from the trend growth of 21%
in prior years. The primary rebalancing targets of the government are to stimulate
private consumption, encourage manufacturing upgrades, drive urbanisation rates
higher and develop infrastructure in western and central China, which have lower
urbanisation ratios.
India: The government has plans to accelerate investments, especially
infrastructure, and drive urbanisation ratios higher. Our economist Richard Iley
forecasts fixed investment to accelerate 14% in FY11 from the trend growth of
10.6% (see “Indian Economics: Eye on the tiger” on 24 December 2010).
Infrastructure spending has been growing at 13-18% pa over the past three years,
supported by the 11th Five-Year Plan (ended in March 2011). However, we are
more positive on India’s private sector capex spending growth, as there are
execution risks on government spending due to fiscal policy exit, which we will
discuss in more detail later.
Indonesia: Our economist Kok Peng Chan forecasts investment growth is set to
accelerate to 8.4-10% in 2011/12 from the trend growth of 7.3%. Improved macro
balance sheet and credit rating upgrades support lower cost of capital, helping to
boost domestic and foreign investments in private sectors (such as real estate,
industrial capacity, and office buildings) and public infrastructure.
Malaysia: Mega infrastructure spending will likely to be a key feature over the next
few years as outlined in the 10th Malaysian Plan (10MP) and augmented in the
2011 budget speech and the Economic Transformation Programme (ETP)
Roadmap. The key difference is that the private sector is expected to take the
greater initiative with the government acting as a facilitator.
2) Headwinds from fiscal and monetary tightening: High risk for India; less for
Indonesia and Malaysia
Given the positive output gap and rising inflation risks, it is already recognised that
monetary normalisation/ tightening will continue in 2011, in the forms of higher policy
rates, reserve requirement ratios, controlled loan quotas and other administrative
measures (see the charts below). Similarly, after the fiscal thrust to combat the
recession in 2008, most Asian governments have begun to withdraw fiscal stimulus.
Fiscal retrenchment should act as a constraint on government spending plans.
Overall, we believe the headwind from fiscal retrenchment and monetary tightening is
strongest in India and weakest in Indonesia. While there are similar mounting concerns
for China, we expect upside risks from government infrastructure spending and new
loan quotas (with our base case forecast of RMB8.1t) in 2011. Our assessment of
monetary and fiscal headwinds on government spending is based on two areas:
Liquidity constraints in the banking system;
The need for government de-leveraging.
There are liquidity squeeze risks in the banking system for the high loan growth
markets. The risk is further fuelled by their high loan-to-deposit ratios and negative real
deposit rates, driving slower deposit growth. Competition for deposits is intensifying,
particularly for smaller banks. Over the past year, due to loose monetary policies in
most Asia ex-Japan markets, the negative real deposit rates have discouraged bank
depositors who are shifting their wealth into other asset classes, such as property,
given low mortgage rates and equities. Deposit growth rates are slower than loan
growth rates in Hong Kong, Indonesia, India, Thailand, Malaysia and Taiwan. Even in
China, deposit growth has been underpinned by corporate deposit rates, which have
been weak (see charts below).
As such, the loan-to-deposit ratios have climbed and are becoming a problem,
particularly in India (LDR rising by 4.7ppt during 2010 to 109%). While we expect the
RBI to hike rates soon, rising food prices in the near term should lead to persisting
negative rates and tight liquidity in the coming months. Our India banks analyst, Vijay
Sarathi, points out that the liquidity deficit could inch up to INR1,800b-1,900b, with
some banks raising 1-month deposits to 9.5%, including some large PSU banks (see
“India Banks Sector: Liquidity blues” dated 16 December 2010).
Aside from India, we believe the risk of tightening liquidity in the banking system also
appears high in Thailand, given its accelerating loan growth, high loan-to-deposit ratio
of 120%, our expectation of higher inflation and persistent negative interest rates. In
Indonesia, while our economist expects the cyclically higher food price inflation to
moderate from 2Q, delayed rate hikes and negative interest rates would pose similar
liquidity concerns on Indonesian banks in the near term. On a 12-month view, however,
modest core inflation and still-loose monetary policy by Bank Indonesia should support
credit growth.
In China, although the loan-to-deposit ratio is low at 67%, and deposit growth matches
loan growth, the liquidity situation in the banking system is still a policy call, depending
on the new loan quota, increase in reserve requirement ratios and policy rate hikes in
2011. Overall, we expect sufficient liquidity provision in the banking system, with our
non-consensus loan quota forecast of RMB8.1t (see page 5 in “Alpha Strategy: Stay
bullish – 2011 outlook” dated 22 November 2011). This forecast is based on a credit to
GDP ratio of 19% (down modestly on the forecast outturn of 20% in 2010) and our
expectation of China’s continued dependence on investment as a growth driver in the
coming two years. Further, sufficient credit quota is needed for government-initiated
investments, which over the past two decades have tended to accelerate in the first
year of the Five-Year Plan (see chart below). We believe there will be enough liquidity
in the banking system to support government spending, especially for the focus areas
(railway infrastructure, rural development and the seven new strategic industries).
Constraint on government spending is the highest in India, in our view, as the
government is uncomfortably in debt, with its general government budget deficits at
6.6% of GDP in FY10. In the aftermath of the recent global financial crisis, Indian and
Chinese governments loosened fiscal policy aggressively. However, this stimulus will
now be more conservative over the coming years, particularly in India.
According to IMF estimates, India is projected to be the most aggressive (among the
Asia ex-Japan and G7 economies) in reducing its debt levels in the next four years. On
IMF figures, India will tighten fiscal policy by nearly 5ppt of GDP in 2011-12, a much
higher figure than the 1.7% tightening in China and 1.4% in Thailand during the same
period. The implication is that while planned government expenditure in India on
infrastructure and rural development is set to rise, upside potential on spending looks
fairly limited, in addition to policy execution risks.
China is in a better position than India. Our economists believe the Chinese
government will turn fiscal policy from extremely aggressive and aggressive in 2009
and 2010 to an accommodative stance in 2011, in order to support local leaders’
political power consolidation, improve public supply of goods (public housing in
particular), and fulfill economic restructuring. We believe upside surprise in government
spending in fixed investment and the strategic industries (new-generation IT, energysaving
and environmental protection, new energy, high-end equipments) are likely.
On the other hand, with an improving macroeconomic balance sheet and less
aggressive fiscal stimulus in 2008-09, the Indonesian government will need only a little
fiscal tightening and can afford to have more expansionary spending plans than other
Asia ex-Japan markets. The government expects to increase capital spending in 2011
by 28% y-y to IDR121.7t (USD13.6b), according to government announcements. This
accounts for about 15% of total government spending, up from 12% in 2010.
To sum up, we believe the headwind from a potential liquidity squeeze in the banking
system and fiscal retrenchment is strongest in India, and weakest in Indonesia and
Malaysia, among emerging Asian countries. We expect upside surprise from the
investment cycle in China, Indonesia and Malaysia driven by either government
spending or by private sectors.
Investment 1: Riding the Inflation Wave
The spectre of Inflation continues to plague the equity markets. A rapid increase of
headline inflation will likely put pressure on market valuations. While we believe the
cyclical weather impact on food prices will moderate in the near term, concerns on
rising non-food inflation may linger longer. We identify sectors that tend to perform well
in an elevated inflationary environment.
Implications for equities
Inflation is clearly the major risk for Asian economies in 2011, as concerns for
aggressive monetary tightening should weigh on markets. The key fundamental point is
whether food price driven inflation leads to a wider pick up in inflation expectations and
a generalised rise in CPI. There are already initial signs of this risk. China’s non-food
CPI has edged up to a decade high. With its WPI rising to close to one standard
deviation above the last 10-year average, India also sees high risks from inflation
pressure.
Sectors likely to benefit from elevated inflation themes
The major concern for Asian markets now is high (and rising) inflation, and markets will
likely struggle to perform. We believe inflation will likely begin to moderate in 2Q11 as
the impact of poor weather on food prices dissipates. That said, inflation levels, in our
view, will stay elevated, given loose monetary policy in the West and the output gap for
most Asian markets turning positive. Under this scenario, three types of sectors tend to
perform well, as the 1993 experience showed:
1) Inflation hedged real assets
Energy, coal, commodities and real estate fall into this category.
Oil: Higher inflationary environment tends to be associated with rising oil prices. As
we have argued earlier, better-than-expected growth in the US would lead to
sustained higher oil prices, posing incremental inflation pressure for Asia. Oil
stocks offer best exposure to oil prices. We prefer both PTTEP (PTTEP TB; BUY;
TP: THB124.60) and Oil & Natural Gas (ONGC IN; BUY; TP: INR1,441.00), whose
share prices all have higher correlations with oil price movement.
Coal: We note that both coal and property stocks carry policy risks, as policy
makers are striving to battle with rising asset prices and inflation. Policy tightening
could continue to create volatility in these sectors. However, we are still bullish on
coal names on a 12-month view, despite the near-term headwind. With tight supply
and China’s heavy dependence on coal, the commodity has essentially become an
inflation hedged real estate. Policy price cap can only work in the very short term,
as coal producers would cut contract sales portions, cut fulfillment rates or provide
lower quality coal on contract price. We prefer Yanzhou Coal (1171 HK; BUY; CP:
HKD23.0) and Noble Group (NOBL SP; Not rated).
Property: It is widely perceived that physical property is a natural hedge to
inflation. We agree. We also believe that much of the policy tightening risks appear
to be priced in, with the sector trading at the bottom P/E levels of the historical
range. Earnings visibility for Chinese property developers is relatively high, as on
average, H-share listed developers have locked in over 70% of our analyst’s 2011E
revenue estimates. We prefer COLI (688 HK; BUY; CP: HKD15.02
Corporate Spending
In this section we focus on two major sub themes:
Corporate spending beneficiaries – including implications for IT services, media,
hotels, equipment and banks;
Manufacturing upgrades in China – focusing on the automation trend and
increasing global competitiveness of Chinese machinery makers.
Corporate spending beneficiaries
Several sectors offer exposure to the theme of a sustained recovery in corporate
spending. In MSCI industry classifications, IT services, hotels, media and airlines, on
our estimates, have over 50% of their revenues coming from corporate, with IT services
the highest at about 75%. Below, we analyse each industry with specific stock picks.
Investment 3: Transition – Plays on
Government Inv’t Upside
Government investment spending may surprise on the upside in several areas, and we
would focus on opportunities in China, Indonesia, Malaysia and Thailand.
China spending: Structural downtrend, with cyclical upside
China is in a transition period, and we believe investors’ long-term expectations are in
the process of downward adjustment. Indeed, it is increasingly apparent that the
infrastructure-building boom is close to an end. It is difficult to envisage China’s high
investment share of GDP at 50% in 2010 to climb much further (compared to 36% for
the BRICs overall and 15% for the G7 developed countries). More importantly, Chinese
policy makers clearly favour a switch to consumption-led growth, instead of investmentled.
However, this does not imply that China will stop building. There is still upside for
fixed investment growth this year, as highlighted earlier:
Historically, infrastructure and construction investment tends to accelerate in the
first year of a new Five-Year Plan. Local governments are still setting double-digit
annual GDP growth rate targets for 2011-15.
A potential decline in property construction activities from a high level based in
2010 can be offset in part by the government’s aggressive target for building social
housing – 10m units in 2011, against 5.8m in 2010 (with about 65% completion
rate). The floor space construction target of social housing may account for 6% of
total residential floor space under construction in 2010. We believe floor space
under construction in 2011 will be up by 15-20% y-y, compared to a 27% y-y rise in
2010.
Faster urbanization process in the western and central China may also provide
upside. The urbanisation rate in central and western China is about 18ppt lower
than that in the coastal provinces, while the total population in the central and
western regions (around 720m) is above that in the eastern and northeastern
regions (590m). China’s policy goal of developing western and central China will
drive the growth in middle class and consumer spending power.
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Inflation, reflation and transition
Three macro themes: Inflation, reflation and economic transition
Riding inflation: Real assets, rising rate beneficiary, pricing power
Plays on capex boom: Selected IT, hotel, media, machinery equipment and banks
Investment upside in China, Indonesia and Malaysia: Commodity, construction
Three important and interwoven macro trends underlie our investment themes for 2011: 1)
Inflation – food prices may stabilise in 2Q, but expanding domestic demand, ample liquidity
and positive output gaps indicate elevated inflation; 1) Reflation – abundant liquidity and low
real rates continue to push investors searching for growth, either in the US, when a cyclical
lift asserts itself, or in Asia, when inflation moderates; and 3) Transition – long-term growth
expectations are being adjusted across Asia ex-Japan (AXJ) markets, with focuses on
China’s transition toward consumption and the investment cycle in ASEAN and India.
We recommend the following ways to benefit from the macro themes, in order of preference:
Riding on higher inflation: Our analysis of a similar period of rising inflation in Asia
and reflation in the US in 1993, suggests three types of sectors tend to perform well: 1)
inflation-hedged real assets (oil, coal, property, etc.); 2) beneficiaries of rising interest
rate (insurers); and 3) companies with strong pricing power (airlines, hotels, landlords,
high-end or branded retailers, etc.). By contrast, autos tend to underperform.
Capex boom beneficiaries: This is an overlooked reflation theme. AXJ capex only
staged a below-trend 10% rebound last year. We believe the outlook is favourable, as
profits are up, confidence high, corporate balance sheets strong, capacity tight and
interest rates low. We like select media, hotel, equipment, bank and tech names.
Government spending plays: China’s investment growth typically accelerates in the
first year of a new Five-Year Plan, supporting upside for select materials, construction
and equipment producers. Delayed reforms and tight liquidity in India lead us to prefer
cement and construction names in Indonesia and Malaysia as investment plays.
We construct three stock baskets (see page 4 for details) to benefit from these themes.
Executive Summary and Three Stock Baskets
Three important and interwoven macro trends underlie our investment themes:
Lingering inflation risk: Expanding Asia ex-Japan domestic demand, still loose
monetary policy, and positive output gaps inevitably invite inflation. Concerns on a
rise of generalised inflation and behind-the-curve tightening may linger this year.
However, tightening measures are likely front-end loaded as cyclical food price
increases should stabilise in 2Q.
Continued reflation in the West: Abnormally low real rates, quantitative easing
and fiscal stimulus provide potential upside to growth. With abundant liquidity,
investors are searching for growth, either in the US, when a cyclical lift asserts
itself, or in Asia, when inflation concerns abate (likely in the middle of the year).
Corporate capex tends to be boosted amid a reflationary environment.
Economic transition: China is rebalancing its economy toward consumption-led
growth, while ASEAN and India are reviving their investment impetus. That said,
we see upside to China’s FAI growth in the first year of a new Five-Year Plan (the
country’s 12th). On the other hand, we think that India may have a high risk in
delivering infrastructure investment, while Indonesia and Malaysia look set to kickstart
their investment cycles.
We recommend having exposure to these macro trends through three investment
themes, in order of preference:
Riding the inflation wave: Our analysis of the 1993 reflation experience suggests
that Hong Kong and Taiwan tend to do well amid liquidity-driven inflation. Three
sectors, in our view, should perform well: 1) real assets – we include in the below
basket Indian and Thai oil stocks as exposure to a strengthened US economy and
oil prices; Chinese coal names could benefit from favourable supply and demand
dynamics despite the short-term price cap; Chinese property on its cheap
valuations; 2) rising rate beneficiaries – we include Taiwanese insurers; and 3)
companies with pricing power – we include airlines, Hong Kong landlords, Chinese
luxury department stores and a Singapore upstream commodity producer.
Beneficiaries of corporate capex boom: Capex is a less-recognised reflation
theme. Asia ex-Japan corporate capex only staged a below-trend 10% rebound
last year. With low rates, high confidence, rising profits and strong balance sheets,
corporates are pressed to increase capex or M&A as capacity tightens and costs
rise. Selective IT services, media, hotels, machinery equipment and banks offer
high exposure to rising corporate spending. In China, strong wage growth pushes
corporates toward more automation. Drivers such as technological progress,
domestic economic scale and increasing global competitiveness also enable
Chinese equipment producers to seek overseas export opportunities.
Plays on government upside surprise: Investors’ long-term growth expectations
for China are being adjusted down as the country is in the process of economic
transition, while expectations for ASEAN and India are increasing. However, we
see investment opportunities in basic materials and construction in China as its FAI
could pose a positive surprise in the first year of a new Five-Year Plan. Cautious
investment sentiment has depressed some of these stocks’ valuations. We are also
positive on the investment cycle in Indonesia and Malaysia. By contrast, we would
be cautious on India’s infrastructure investment on potential execution
disappointment. In our view, cement and construction stocks in Indonesia and
Malaysia offer best exposure to the cycle on attractive valuations.
We construct three stock baskets as potential exposure to the above three macro
themes: Inflation, reflation and transition. See the following tables for stock names and
valuation details. More analysis on each theme and stocks are in the text.
Macro Themes: Inflation, Reflation and
Transition
We have bullish views on Asian equities, but believe the risk is heavily shaped by three
macro-economic themes: Inflation, reflation and economic transition. These three
macro themes also underlie our 2011 investment themes, which are centred on inflation
implications for consumers and sectors, corporate capex beneficiaries and government
spending in Asia.
Inflation: The centre of growth gravity is shifting to emerging markets, as global
rebalancing progresses. However, inflation is quickly rising as a major threat for
Asia, fuelled by a rapid run-up in commodity prices amid this reflationary
environment. China has moved to curb the inflation threat gradually, while other
policy markets elsewhere in Asia ex-Japan are perceived to be more sanguine and
may have been behind the curve. Moderate rate tightening so far is partly due to
the uncertainty of the recovery trajectories in the developed markets (DM). But
DMs’ growth acceleration, particularly in the US, could pose upside risk to higher
inflation in Asia ex-Japan (AXJ). Most of the rising inflation in AXJ so far is
dominated by food prices (mainly in vegetables); however, whether a higher food
price morphs into a rise in general inflation is a major tail risk to Asia.
Reflation: It is clear there is too much debt in the developed world, particularly by
consumers, driving the recent US recession (from December 2007 to June 2009
according to the National Bureau of Economic Research). There has been a great
swap occurring between consumers and governments, with governments
expanding their balance sheets aggressively by assuming more debt, and central
banks keeping policy rates at record lows. As a result, our economists do not
expect a double-dip in the US or the Eurozone (see “Global outlook: Tug of War” in
December 2010), where abundant liquidity and low rates have given the
economies a cyclical lift, reflected in recent better-than-expected macro data. We
believe abundant liquidity and low real rates will continue to lead investors
searching for growth, either in the US when a cyclical lift asserts itself or in Asia
when inflation moderates and policy tightening risks abate. Asset prices have
climbed in this environment, but associated policy risks also escalated. Corporate
capex is another overlooked area that should also be boosted under reflationary
stimulus.
Transition: By contrast, Asian governments are striving to rebalance their
economies toward domestic demand, through consumption (in China) or
investment (in ASEAN and India). Low debt levels in Asia ex-Japan and healthy
balance sheets for both consumers and corporates in the region point to a stronger
growth prospect. Long-term growth expectations, however, are in the process of
(upward or downward) adjustment across Asia ex-Japan markets as a result. A
consumption-led growth inevitably means slower long-term growth ahead, while the
beginning of the investment cycle tends to accelerate economic growth. That said,
during this transition period for Asia ex-Japan markets, we still see cyclical upside
risks in China’s investment growth due to the start of the new 12th Five-Year Plan,
but downside risks in ASEAN and India due to execution risks and tight liquidity.
In the following sub-sections, we look at the three macro themes and their implications
in more detail.
Inflation: Cyclical drivers may fade, but concern will stay
The spectre of inflation continues to plague equity markets. Investors’ concerns are
primarily centred on three markets, China, India and Indonesia, all of which have seen
surging food prices in recent months.
Our conclusion is that CPI may start to moderate for the three countries in 2Q2011 as
the impact of near-term poor weather fades. We believe that moderating headline CPI
should give markets a temporary boost. However, inflation levels should stay elevated
relative to 2009/10 levels, and concerns about higher generalised inflation will likely
stay, in our view, due to other medium-term and structural drivers. Five drivers to
inflation are:
Supply-side disruptions (short-term cyclical factors): Extreme weather conditions
around the world cause supply-side shortage on food (heavy rains in India and
Indonesia, and snow in China).
Improving US growth outlook (medium-term cyclical factors): Recently improving
macro data in the US has driven the oil price to around USD91/bbl, posing
incremental risk to higher inflation in Asia. However, we believe the impact will be
of limited duration as the West still has a large negative output gap, which is
deflationary.
Easy liquidity conditions (medium-term cyclical factors): While policy rates
remain low across Asia, Chinese policy makers have started tightening and money
growth in China is moderating.
Positive output gaps (medium-term cyclical factors): AXJ domestic demand
continue to expand, while output gaps across most markets are turning positive, in
our estimates. Above-trend growth by definition will lead to higher inflation until
monetary policy moves toward restrictive levels.
Higher income and improving diet in Asia (structural driver) Strong emerging
market income growth is leading to a rapid improvement in diet, reflected in strong
demand for fresh vegetables, meat, dairy, and branded foods.
1) Short-term cyclical driver: A weather-related food crunch
Investors’ focus is centred on India, Indonesia and China (and to some extent, on
Korea) where food CPI has surged 12-18% y-y. There are different features in this cycle
of inflation. Most inflation in these three markets is caused by poor weather conditions
(heavy rains and snow), with price spikes dominated by vegetables (onions, tomatoes,
and cauliflower) and spices (such as chili). On the other hand, the price increases for
meat and poultry are in line with overall food inflation. Some of the food items that have
had extreme price spikes are:
India: Vegetables (59% y-y in December 2010), condiments & spices (38% y-y)
and chicken (34% y-y).
Indonesia: Spices (49% y-y in December 2010), cereal, cassava & related
products (27% y-y), and vegetables (20% y-y).
China: Vegetables (21% y-y in November 2010) and eggs (18% y-y).
Despite the rising food prices, the good news is that vegetable crops are harvested at
frequent intervals. Barring continued extreme weather conditions, we feel it is
reasonable to assume that vegetable food inflation should moderate by March/April
given vegetables’ much shorter crop duration, driving down food inflation by spring.
Indeed, China’s frequent retail agriculture products and vegetables surveyed by the
National Bureau of Statistics already showed sequential declines in December 2010 (for
instance, eggs are down 1.2% m-m).
The bottom line is that while the level of food prices may stay high longer, the rate of
food price increases may slow in the coming months, due to a high base effect and
abating cyclical factors. In the coming few months, investors may shift their focus to
search for signs of inflation peaking.
We believe China may see earlier relief in food prices and headline inflation, boosting
equity market performance. At a macro level, the Input Prices Index of PMI is a good
indicator for future inflation direction. While one month doesn't make a trend, the HSBC
PMI Input Prices for China may have peaked, with December 2010 down 8.5 points
sequentially to 72.3. If this downward trend continues in January, we should expect
moderation in China’s CPI.
2) The 1993-94 Experience – Inflation in Asia and reflation in the US
While short-term weather issues should soon fade, other inflation drivers will likely stay
longer – such as ample excess global liquidity. Our economist believes the US Federal
Reserve will keep monetary policy loose and not raise rates until 4Q12 (see “North
America Outlook: No Quick Fix” in December 2010).
In 1993 there was a similar period of rising inflation in Asia and reflation in the US to
what we are experiencing now. Due to the recession in the US from July 1990 to March
1991, the Fed cut rates from 8.25% in June 1990 to 3.00% in September 1992, and
kept the rates at trough levels for 17 months until February 1994. The inflation pressure
began to intensify in the middle of 1993 and did not peak until August 1994. From the
historical performance in 1993, it is clear that during the initial period of rising inflation,
Asian equities performed well. However, a continued rise of generalised inflation,
coupled with the monetary tightening by the Fed eventually caused a correction in
1994.
At a sector level, the companies that possess the following features performed well in
1993 when inflation was rising:
Real assets as a hedge against potentially higher inflation: Commodities
(particularly coal) and real estate sectors were up 116% and 91% in 2H93,
compared to Asia ex-Japan up 60% for the same period.
Beneficiaries of rising interest rates: Insurers rallied 90% during the period.
Companies that have strong pricing power: technology (up 189% in 2H93) and
consumer retailers (up 87%) were also outperforming.
On the other hand, consumer discretionary, mainly autos, were the major victims,
underperforming the market by 32% in 2H93, as rising inflation and interest rates
undermined consumers’ purchasing power.
While today’s reflation and inflation scenario is similar to the 1993 experience, there are
a few differences:
North Asia last year had not experienced a significant rally before facing this
inflation pressure. By contrast, ASEAN and India had better performance in 2010
and are trading at a premium to Asia ex-Japan overall. Even if the monetary
policies in ASEAN and India have not turned restrictive, rising inflation can pose a
greater threat to the markets, in our opinion.
In Asia, the inflation pressure so far has been concentrated in food, particularly in
vegetable prices. Whether vegetable price-driven inflation leads to a wider pick up
in inflation expectations and results in generalised rise in CPI, is something that will
have to be watched closely. A generalized rise in CPI should lead to more
aggressive tightening, which would be negative for equities.
In 1993, the combined weights of China and India accounted for less than 10% of
MSCI AXJ, while Hong Kong, Korea, Taiwan, Singapore and Thailand were the
major markets in the regional index. By contrast, China and India, combined,
account for a 36% weight of MSCI Asia ex-Japan today, and China’s growth
outlook and policy measures clearly have a far more influential impact than before.
3) The oil risk
If growth in the US continues to accelerate this year, commodity prices – particularly oil
– could become a major headwind for growth in Asia, as higher oil prices would lift
headline inflation, and prompt more policy tightening. With relatively high weights of oil
and fuel related items in CPI, Malaysia, India, Thailand and Indonesia are more
sensitive to domestic fuel price spikes.
However, these countries also manage their domestic fuel prices actively, while Korea,
Hong Kong, Singapore and Taiwan follow a floating fuel price mechanism, which mark
their domestic gas price to the market regularly. The consequence of domestic oil price
intervention is high levels of subsidy burden in Indonesia, Malaysia, and India.
The bottom line is that if the oil price rises and is sustained above USD100/bbl, India,
Indonesia and China would all probably see incremental pressure in their headline CPI,
given their already high inflation levels.
4) Structural driver – rising income and demand in Asia
Rising Asia ex-Japan consumer spending power is a secular trend in Asia, particularly
in the three major emerging markets – China, India and Indonesia. The trend of rising
consumer demand in Asia is intact (as we have analysed in our report last year
“Thematic Strategy: Tipping points for CHII consumer” dated 9 September 2010). To
recap, in the report we noted that we expect Asia ex-Japan consumption, particularly in
China, India and Indonesia (CHII) to continue to boom, driven by three structural
factors:
The rise of the middle class and higher income to drive consumer spending;
Continued urbanisation to drive consumption upgrades;
Supportive policy measures to drive lower savings ratios and higher leverage.
Rising wage growth tends to lead to structurally higher inflation, especially when wage
growth is higher than nominal GDP growth. A lot of attention was focused on China’s
accelerating labour wage growth in late 2009 and early 2010, partly due to labour
shortages in the costal areas. Indeed, some economists have attributed this
accelerating growth to the approach of a Lewisian turning point at which labour
shortages and wage increases occur. Arthur Lewis won a Nobel Prize for arguing in a
1954 paper that a developing country with “surplus” agricultural labour could grow its
industrial sector for years without wage inflation as it absorbs that surplus.
While it is debatable whether there is a labour shortage threat in China, it is clear that
labour supply growth in China is firmly on a decelerating trend. A tighter labour supply
would lead to faster wage growth. Japan’s wage and labour supply data (from 1965-
2009) demonstrates this point. In Japan, decelerating labour supply growth tends to
lead to higher-than-nominal-GDP labour wage growth, lifting household income to GDP
ratios and consumer purchasing power.
The causal relation is also true in China. Labour supply growth in China has
decelerated from 1% in 2004 to 0.7% in 2009. The United Nation Population Division
forecasts a further deceleration in labour growth to 0.5% during 2011-15. The chart
below shows that China’s negative gap between wage and nominal GDP growth has
narrowed since 2004. Wage growth in 2009 for the first time significantly outstripped
nominal GDP growth. We expect a trend of faster wage growth in China to persist.
Despite these secular drivers, the major cyclical headwinds to consumer spending
growth this year include elevated inflation, the withdrawal of selective government
stimuli (auto sales tax reductions) and a high base in 2010.
Rising inflation would erode consumers’ purchasing power and lead to slower real
consumer spending growth. Our economists forecast a moderate increase in inflation
across most Asia ex-Japan markets, with China and Hong Kong likely experiencing 1.1-
1.3ppt higher CPI in 2011. There could be further upside inflation risks for China, India
and Indonesia, as a result of rising food prices and the aftermath of ultra loose
monetary policies in 2009.
Reflation: Corporate capex will be boosted further
It is well known that reflationary policies tend to stimulate asset prices. It is less
recognised that corporate spending should also be boosted, in our view, under
aggressive fiscal stimulus and loose monetary policies. Furthermore, corporate capex
plays typically carry less policy risks than asset price plays, especially when
governments across Asia have escalated their tightening focus on property.
Non-financial corporates were at the centre of the recession a decade ago in the
developed world, but in the recent recession, the financials and households were at the
centre. The downturn, of course, still hit non-financial businesses. However, the
corporate sector has staged a V-shaped profit rebound amidst the lacklustre GDP
recovery in the developed world. Indeed, corporate fixed investment spending growth in
the US turned positive in 2Q10 and rose 7% y-y in 3Q10. That said, in terms of
investment to GDP ratio, the level of investment in the corporate sector is still well
below trend (see charts below).
A year ago we highlighted the upside potential for US capex spending, with an
investment focus on US technology spending recovery (“Thematic Strategy – A further
upswing for tech” dated 12 November 2009). US corporate tech spending registered a
stellar rebound since 1Q10, rising 11-13% y-y. The major beneficiary has been Indian
IT services companies, which rallied 33% in 2010 (compared to the MSCI India of 15%
gain).
The picture of Asian corporate capex spending is similar. Asian capex slumped 7% y-y
in 2009, compared to an increase of 21-22% in 2007/08. There was a V-shaped capex
recovery in 2010; however, the rebound was just 11%, with the capex-to-sales ratio still
low at 11% in 2010. Asian corporates are not unfamiliar with cutting capex. Following
the Asian and TMT crises, Asian companies showed persistent capex discipline,
thereby helping restore balance sheets and drive high profitability.
However, looking ahead, we believe corporate capex globally will begin to pick up
strongly, on buoyant confidence, tight capacity utilisation, high levels of cash in balance
sheets and low leverage ratios. In the US, the recovery of corporate capex should
broaden to other categories, particularly to spending on equipment. With a sharp slump
in equipment spending growth in the US during the recession (down 30% in both 2Q
and 3Q09), the equipment investment to GDP ratio collapsed. The recovery of the
equipment spending has just begun in the US and should continue.
Except for the Taiwan tech sector, capex spending growth in 2010 was well below trend
across Asia ex-Japan markets. Korea, Japan, Singapore and Indonesia still registered
negative capex growth last year, compared to the double digit trend growth rates during
2006-08. Among cyclical sectors, energy and industrial companies across markets have
reduced their capex aggressively, even in 2010 when the global recovery began to gain
some foothold.
Cash in corporate balance sheets in most Asian markets has been near or at record
highs for the past 16 years. The ratio of free cash flow (FCF) as a percentage of assets
stands at 2.2% in 2010 for Asia ex-Japan, close to the record high of 2.8% in 2003
when SARS hit most Asian markets. The ratios for Hong Kong and Malaysia jumped to
a record high in 2010, providing sufficient ammunition for capex spending or M&A
activities.
Another driver to rising corporate capex is increasing capacity constraints. As industrial
growth remains strong in most markets, output gaps in most markets are turning
positive, on our estimates, driving up capacity utilisation rates. Together with low capex
over the last 2-3 years, the need for capacity expansion is pressing. The investment
implications are centred on the industrials sector, selective materials, and technology
stocks. We will analyse these implications in more detail in later sections.
Another important implication is that we believe M&A activities could pick up
significantly in 2011. There are four reasons for this:
Corporate cash level is high, as we just highlighted, and leverage is low, with Asia
ex-Japan net debt to equity ratio at a record low 25% in 2010.
Valuations are at neutral levels, with trailing P/BV for MSCI AXJ and MSCI AXJ
Small Cap at 2.1x and 1.5x, respectively, which are close to their long-term
averages. The average M&A deal premium in Asia ex-Japan is still low at 14%,
down from 21% in 2007 and 2008. Given concerns on rising costs, we suspect that
companies will increasingly consider expansion through inorganic growth via
M&As, rather than organic growth, which is much slower.
M&A volume tends to lag the equity market cycle, as corporate confidence
recovers gradually. Current levels of M&A activity is still low, when measured as a
proportion of market cap (19% in 2010, compared to the peak of 39% in 2008).
Improving equity market performance is a lead indicator for M&A, as the chart
below shows.
Cross-border M&A activity in Asia should increase, as companies are looking to
access overseas end markets, build a regional platform or secure resources. The
recent acquisition of Kim Eng by Maybank is an example, as the bank would seek
to transform itself into a leading stockbroker in the ASEAN region.
Several companies have hinted their intent to conduct inorganic growth in the nearterm,
including, for example, Shinsegae (004170 KS; BUY; CP: KRW572,000), Yuanta
FHC (2885 TT; REDUCE; CP: TWD22.40), PetroChina (857 HK; BUY; CP: HKD10.52)
and Indorama Ventures (IVL TH; Not rated; CP: THB41.75).
Transition: Government’s balance between structural
adjustment and fiscal retrenchment
Governments across Asia ex-Japan markets are striving to achieve a balance between
structural adjustment and fiscal retrenchment. However, probabilities of upside
surprises in government-led investments still exist, in our view. We conclude that there
could be upside to the investment cycles in China, Indonesia and Malaysia. Our
analysis is centred on governments’ aims and constraints to identify potential areas of
upside surprises from two perspectives:
Structural economic adjustments;
Headwinds from fiscal retrenchment and monetary tightening.
One of the important long-term objectives for most Asian governments is to rebalance
their economies away from a heavily export-dependent growth model toward a
consumption and domestic demand-driven growth. On the other hand, Asian
governments (particularly in China) have been embarking on gradual de-leveraging
since early 2010, reducing the amount of their debt used to boost growth during the
recent global credit crisis by withdrawing fiscal stimulus, controlling credit quotas and
tightening monetary policies. Investment and infrastructure-related industries, as a
result of this governmental tightening, have underperformed in 2010 on cautious growth
expectations. Most of China and India materials, capital goods (infrastructure
construction/ clean energy related stocks) and real estate stocks were underperforming.
We believe the government investment theme will continue to face headwinds from
fiscal and monetary tightening in 2011, especially when the output gap is turning
positive on our estimates, and inflation risk is rising across Asian markets. That said, we
believe there are still selective money-making investment and infrastructure themes,
such as infrastructure build-up in Indonesia and manufacturing upgrade and social
housing in China.
1) Structural economic adjustment with a different focus
The export growth model adopted by Asian economies is being challenged. With
demand growth from developed economies likely to remain tepid, the need to rebalance
Asia’s growth engine toward domestic demand is well recognised. Since 2008, policy
makers have relied on the easier path of boosting domestic demand through ultra-loose
monetary policy and aggressive fiscal expansion.
Asia’s policy makers will continue to face the challenge of boosting domestic demand
on a sustainable basis, in our view. Depending on their development phase and the
structure of their economies, Asian governments have different areas to focus their
rebalancing on. For India, Indonesia, Thailand and the central and western part of
China, the need for further infrastructure build-up is clear, given their low urbanisation
ratios (see the chart above) and continuous migration of the rural population to urban
areas. From Japan’s experience we can see that before the urbanisation ratio reaches
55% fixed investment growth tends to stay at high levels, lifting investment-to-GDP
ratios. On the other hand, China’s overall investment share in GDP is already at high
levels and it is difficult to envisage the ratio getting much higher. We expect moderating
investment growth ahead in China.
On the fixed investment front, our economists forecast that six Asian markets are set to
have above-trend growth: India, Indonesia, Thailand, Malaysia, Taiwan and Korea (see
the chart below). Among Asian markets, as we’ve highlighted, three countries – China,
India and Indonesia – are expected to lead the domestic demand growth in the region.
Our economists expect both India and Indonesia to see above-trend and accelerating
fixed investment growth – 14%/15% in India for FY11/12 and 8%/10% in Indonesia for
2011/12. Growing urbanisation of the two countries and the governments’ commitments
to improve infrastructure facilitates should drive higher growth rates.
It is worth highlighting the different focuses of the three countries, given their size
(about 80% of the region’s GDP in 2010, on a PPP basis) and high investment growth
rates.
China: Given the already high investment to GDP ratio of 50% (compared to 36%
for the BRICs overall and 15% for the G7 developed countries), the aim of the
policy measures is no longer to boost investment further. Our economist forecasts
fixed investment growth to decelerate to 18% in 2011 from the trend growth of 21%
in prior years. The primary rebalancing targets of the government are to stimulate
private consumption, encourage manufacturing upgrades, drive urbanisation rates
higher and develop infrastructure in western and central China, which have lower
urbanisation ratios.
India: The government has plans to accelerate investments, especially
infrastructure, and drive urbanisation ratios higher. Our economist Richard Iley
forecasts fixed investment to accelerate 14% in FY11 from the trend growth of
10.6% (see “Indian Economics: Eye on the tiger” on 24 December 2010).
Infrastructure spending has been growing at 13-18% pa over the past three years,
supported by the 11th Five-Year Plan (ended in March 2011). However, we are
more positive on India’s private sector capex spending growth, as there are
execution risks on government spending due to fiscal policy exit, which we will
discuss in more detail later.
Indonesia: Our economist Kok Peng Chan forecasts investment growth is set to
accelerate to 8.4-10% in 2011/12 from the trend growth of 7.3%. Improved macro
balance sheet and credit rating upgrades support lower cost of capital, helping to
boost domestic and foreign investments in private sectors (such as real estate,
industrial capacity, and office buildings) and public infrastructure.
Malaysia: Mega infrastructure spending will likely to be a key feature over the next
few years as outlined in the 10th Malaysian Plan (10MP) and augmented in the
2011 budget speech and the Economic Transformation Programme (ETP)
Roadmap. The key difference is that the private sector is expected to take the
greater initiative with the government acting as a facilitator.
2) Headwinds from fiscal and monetary tightening: High risk for India; less for
Indonesia and Malaysia
Given the positive output gap and rising inflation risks, it is already recognised that
monetary normalisation/ tightening will continue in 2011, in the forms of higher policy
rates, reserve requirement ratios, controlled loan quotas and other administrative
measures (see the charts below). Similarly, after the fiscal thrust to combat the
recession in 2008, most Asian governments have begun to withdraw fiscal stimulus.
Fiscal retrenchment should act as a constraint on government spending plans.
Overall, we believe the headwind from fiscal retrenchment and monetary tightening is
strongest in India and weakest in Indonesia. While there are similar mounting concerns
for China, we expect upside risks from government infrastructure spending and new
loan quotas (with our base case forecast of RMB8.1t) in 2011. Our assessment of
monetary and fiscal headwinds on government spending is based on two areas:
Liquidity constraints in the banking system;
The need for government de-leveraging.
There are liquidity squeeze risks in the banking system for the high loan growth
markets. The risk is further fuelled by their high loan-to-deposit ratios and negative real
deposit rates, driving slower deposit growth. Competition for deposits is intensifying,
particularly for smaller banks. Over the past year, due to loose monetary policies in
most Asia ex-Japan markets, the negative real deposit rates have discouraged bank
depositors who are shifting their wealth into other asset classes, such as property,
given low mortgage rates and equities. Deposit growth rates are slower than loan
growth rates in Hong Kong, Indonesia, India, Thailand, Malaysia and Taiwan. Even in
China, deposit growth has been underpinned by corporate deposit rates, which have
been weak (see charts below).
As such, the loan-to-deposit ratios have climbed and are becoming a problem,
particularly in India (LDR rising by 4.7ppt during 2010 to 109%). While we expect the
RBI to hike rates soon, rising food prices in the near term should lead to persisting
negative rates and tight liquidity in the coming months. Our India banks analyst, Vijay
Sarathi, points out that the liquidity deficit could inch up to INR1,800b-1,900b, with
some banks raising 1-month deposits to 9.5%, including some large PSU banks (see
“India Banks Sector: Liquidity blues” dated 16 December 2010).
Aside from India, we believe the risk of tightening liquidity in the banking system also
appears high in Thailand, given its accelerating loan growth, high loan-to-deposit ratio
of 120%, our expectation of higher inflation and persistent negative interest rates. In
Indonesia, while our economist expects the cyclically higher food price inflation to
moderate from 2Q, delayed rate hikes and negative interest rates would pose similar
liquidity concerns on Indonesian banks in the near term. On a 12-month view, however,
modest core inflation and still-loose monetary policy by Bank Indonesia should support
credit growth.
In China, although the loan-to-deposit ratio is low at 67%, and deposit growth matches
loan growth, the liquidity situation in the banking system is still a policy call, depending
on the new loan quota, increase in reserve requirement ratios and policy rate hikes in
2011. Overall, we expect sufficient liquidity provision in the banking system, with our
non-consensus loan quota forecast of RMB8.1t (see page 5 in “Alpha Strategy: Stay
bullish – 2011 outlook” dated 22 November 2011). This forecast is based on a credit to
GDP ratio of 19% (down modestly on the forecast outturn of 20% in 2010) and our
expectation of China’s continued dependence on investment as a growth driver in the
coming two years. Further, sufficient credit quota is needed for government-initiated
investments, which over the past two decades have tended to accelerate in the first
year of the Five-Year Plan (see chart below). We believe there will be enough liquidity
in the banking system to support government spending, especially for the focus areas
(railway infrastructure, rural development and the seven new strategic industries).
Constraint on government spending is the highest in India, in our view, as the
government is uncomfortably in debt, with its general government budget deficits at
6.6% of GDP in FY10. In the aftermath of the recent global financial crisis, Indian and
Chinese governments loosened fiscal policy aggressively. However, this stimulus will
now be more conservative over the coming years, particularly in India.
According to IMF estimates, India is projected to be the most aggressive (among the
Asia ex-Japan and G7 economies) in reducing its debt levels in the next four years. On
IMF figures, India will tighten fiscal policy by nearly 5ppt of GDP in 2011-12, a much
higher figure than the 1.7% tightening in China and 1.4% in Thailand during the same
period. The implication is that while planned government expenditure in India on
infrastructure and rural development is set to rise, upside potential on spending looks
fairly limited, in addition to policy execution risks.
China is in a better position than India. Our economists believe the Chinese
government will turn fiscal policy from extremely aggressive and aggressive in 2009
and 2010 to an accommodative stance in 2011, in order to support local leaders’
political power consolidation, improve public supply of goods (public housing in
particular), and fulfill economic restructuring. We believe upside surprise in government
spending in fixed investment and the strategic industries (new-generation IT, energysaving
and environmental protection, new energy, high-end equipments) are likely.
On the other hand, with an improving macroeconomic balance sheet and less
aggressive fiscal stimulus in 2008-09, the Indonesian government will need only a little
fiscal tightening and can afford to have more expansionary spending plans than other
Asia ex-Japan markets. The government expects to increase capital spending in 2011
by 28% y-y to IDR121.7t (USD13.6b), according to government announcements. This
accounts for about 15% of total government spending, up from 12% in 2010.
To sum up, we believe the headwind from a potential liquidity squeeze in the banking
system and fiscal retrenchment is strongest in India, and weakest in Indonesia and
Malaysia, among emerging Asian countries. We expect upside surprise from the
investment cycle in China, Indonesia and Malaysia driven by either government
spending or by private sectors.
Investment 1: Riding the Inflation Wave
The spectre of Inflation continues to plague the equity markets. A rapid increase of
headline inflation will likely put pressure on market valuations. While we believe the
cyclical weather impact on food prices will moderate in the near term, concerns on
rising non-food inflation may linger longer. We identify sectors that tend to perform well
in an elevated inflationary environment.
Implications for equities
Inflation is clearly the major risk for Asian economies in 2011, as concerns for
aggressive monetary tightening should weigh on markets. The key fundamental point is
whether food price driven inflation leads to a wider pick up in inflation expectations and
a generalised rise in CPI. There are already initial signs of this risk. China’s non-food
CPI has edged up to a decade high. With its WPI rising to close to one standard
deviation above the last 10-year average, India also sees high risks from inflation
pressure.
Sectors likely to benefit from elevated inflation themes
The major concern for Asian markets now is high (and rising) inflation, and markets will
likely struggle to perform. We believe inflation will likely begin to moderate in 2Q11 as
the impact of poor weather on food prices dissipates. That said, inflation levels, in our
view, will stay elevated, given loose monetary policy in the West and the output gap for
most Asian markets turning positive. Under this scenario, three types of sectors tend to
perform well, as the 1993 experience showed:
1) Inflation hedged real assets
Energy, coal, commodities and real estate fall into this category.
Oil: Higher inflationary environment tends to be associated with rising oil prices. As
we have argued earlier, better-than-expected growth in the US would lead to
sustained higher oil prices, posing incremental inflation pressure for Asia. Oil
stocks offer best exposure to oil prices. We prefer both PTTEP (PTTEP TB; BUY;
TP: THB124.60) and Oil & Natural Gas (ONGC IN; BUY; TP: INR1,441.00), whose
share prices all have higher correlations with oil price movement.
Coal: We note that both coal and property stocks carry policy risks, as policy
makers are striving to battle with rising asset prices and inflation. Policy tightening
could continue to create volatility in these sectors. However, we are still bullish on
coal names on a 12-month view, despite the near-term headwind. With tight supply
and China’s heavy dependence on coal, the commodity has essentially become an
inflation hedged real estate. Policy price cap can only work in the very short term,
as coal producers would cut contract sales portions, cut fulfillment rates or provide
lower quality coal on contract price. We prefer Yanzhou Coal (1171 HK; BUY; CP:
HKD23.0) and Noble Group (NOBL SP; Not rated).
Property: It is widely perceived that physical property is a natural hedge to
inflation. We agree. We also believe that much of the policy tightening risks appear
to be priced in, with the sector trading at the bottom P/E levels of the historical
range. Earnings visibility for Chinese property developers is relatively high, as on
average, H-share listed developers have locked in over 70% of our analyst’s 2011E
revenue estimates. We prefer COLI (688 HK; BUY; CP: HKD15.02
Corporate Spending
In this section we focus on two major sub themes:
Corporate spending beneficiaries – including implications for IT services, media,
hotels, equipment and banks;
Manufacturing upgrades in China – focusing on the automation trend and
increasing global competitiveness of Chinese machinery makers.
Corporate spending beneficiaries
Several sectors offer exposure to the theme of a sustained recovery in corporate
spending. In MSCI industry classifications, IT services, hotels, media and airlines, on
our estimates, have over 50% of their revenues coming from corporate, with IT services
the highest at about 75%. Below, we analyse each industry with specific stock picks.
Investment 3: Transition – Plays on
Government Inv’t Upside
Government investment spending may surprise on the upside in several areas, and we
would focus on opportunities in China, Indonesia, Malaysia and Thailand.
China spending: Structural downtrend, with cyclical upside
China is in a transition period, and we believe investors’ long-term expectations are in
the process of downward adjustment. Indeed, it is increasingly apparent that the
infrastructure-building boom is close to an end. It is difficult to envisage China’s high
investment share of GDP at 50% in 2010 to climb much further (compared to 36% for
the BRICs overall and 15% for the G7 developed countries). More importantly, Chinese
policy makers clearly favour a switch to consumption-led growth, instead of investmentled.
However, this does not imply that China will stop building. There is still upside for
fixed investment growth this year, as highlighted earlier:
Historically, infrastructure and construction investment tends to accelerate in the
first year of a new Five-Year Plan. Local governments are still setting double-digit
annual GDP growth rate targets for 2011-15.
A potential decline in property construction activities from a high level based in
2010 can be offset in part by the government’s aggressive target for building social
housing – 10m units in 2011, against 5.8m in 2010 (with about 65% completion
rate). The floor space construction target of social housing may account for 6% of
total residential floor space under construction in 2010. We believe floor space
under construction in 2011 will be up by 15-20% y-y, compared to a 27% y-y rise in
2010.
Faster urbanization process in the western and central China may also provide
upside. The urbanisation rate in central and western China is about 18ppt lower
than that in the coastal provinces, while the total population in the central and
western regions (around 720m) is above that in the eastern and northeastern
regions (590m). China’s policy goal of developing western and central China will
drive the growth in middle class and consumer spending power.
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