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UBS Investment Research
Asia Equity Strategy
How to think about oil and Asian equities
�� A framework to think about oil shocks
This note offers a framework of how oil shocks affect Asian equities and not a
prediction of the oil price (our global team forecasts a 2011 average of US$85/bbl
on fundamentals). Not surprisingly, Asia tends to underperform as a net importer.
�� India the most vulnerable to an oil shock; Malaysia the least
From a macro perspective, higher oil prices have implications on: 1) growth; 2)
inflation; 3) budget balances; and 4) the currency. The countries that are
considered to be most at risk are those that already face the greater inflation and
current account pressures. On these metrics India looks the most vulnerable;
Indonesia and China look somewhat at risk; and Malaysia looks the least affected.
�� What happened during the oil shock around the First Gulf War?
This period offers the cleanest comparison of an oil shock (pre-recession/financial
crisis). Between Aug and Oct 1990, the oil price doubled from US$20 to US$40
(which as a drag on consumption we think is equivalent to US$125 Brent crude
today), and Asian markets fell by 29% whilst 12M forward earnings fell by 20%.
This happened against a backdrop of modest valuations at 11.6x PE and 1.6x PB.
�� Prefer PetroChina H; Autos, Korea/Taiwan Transport relatively expensive
The Energy sector should be a beneficiary of higher oil prices but valuations do not
look particularly attractive – PetroChina is our Oil team’s top pick. Autos, Korea
and Taiwan Transport are sensitive to oil and look expensive versus history, based
on market-relative PB. In the last section, we have reproduced the oil section of our
detailed note on commodities ‘Anomalies from the rise in commodities’, dated 25
Jan 2011.
Unsurprisingly, we’ve been getting many questions about the impact of rising
oil prices on Asian equities. That’s what we cover in this note. Our sense is that
investors are nervous about this precisely because it is difficult to predict: the
very uncertainty of events in North Africa and the Middle East means risk
premiums are vulnerable – when events are deeply uncertain, risk premiums
typically rise, not fall. Larry Hatheway, our global asset allocation strategist, has
published a note to reduce risk assets weightings yesterday (‘Tactical risk
reduction’ 24 February 2011). At the same time we also suspect that (like us)
most investors are hoping that oil prices recede – in other words positioning is
not set for a rapid and aggressive spike in oil prices from here.
This note is not an examination of events in the Middle East and North Africa.
Nor is it a prediction of where oil prices are likely to go – for reference our oil
team think that ex current events, the oil price if driven by fundamentals should
be at US$85/barrel.
The purpose of this note is to provide a framework for thinking about oil spikes.
In this note we 1) look at past correlations between Asia and the oil price 2)
address the economic implications on growth, inflation, fiscal balances, trade
balances and as a result policy responses, with the help of our economics team
3) look back at the oil shock in August 1990 from Iraq’s invasion of Kuwait (we
explain why we have taken this episode, slightly later) both in terms of earnings
and performance, 4) examine the impact on the oil sector itself, but also which
sectors within countries look vulnerable and expensive (PetroChina ‘H’ is our
Oil team’s preferred pick; Autos, Korea/Taiwan Transport look relative
expensive on a PB basis) 5) we reproduce the oil section of our note from 25
January 2011 “Anomalies from the rise in commodities” where we looked at the
specific impact of rising commodity prices on individual stocks.
1. Asia Ex Japan’s relative performance vulnerability
First up – Asia ex Japan’s relative performance during oil spikes. Asia tends to
underperform other emerging markets, and the world index when the oil price is
rising. This is hardly a surprise as the oil price is simply a transfer payment
mechanism with Asia a net importer of oil.
At a relative level, Charts 4-6 shows the performance of Malaysian equities to
the region, as the region’s only oil exporting economy – it tends to be the safe
haven historically in relative performance terms.
2. The macro angle
Going beyond this simplistic market performance analysis, and turning to the
macro impact, we would highlight our colleague Duncan Wooldridge’s more
detailed note on this yesterday, (‘Texas Tea and Asia – Who is Exposed?’ dated
24th February 2011).
We see four things to consider from moves in the oil prices. Firstly, the impact
on growth, secondly the impact on inflation, thirdly the impact on budget
balances and finally the impact on current accounts and therefore the potential
impact on the currency.
1. Growth. What differentiates the moves today is that we are experiencing a
potential supply shock, not a demand shock. The ability to withstand this is less
as a result. Looking at the growth impact and taking simplistic data on oil
consumption as a share of GDP, reveals that most countries in Asia ex Japan are
at similar levels of consumption – prima facie, we estimate growth would be
impacted in a similar fashion of around 50 basis points for every US$ 10 move
in oil prices.
The only country in the region where oil consumption as a percentage of GDP is
in double-digit is Singapore. This is somewhat misleading as Singapore is a
regional refining centre, so a lot of the oil is actually re-exported as refined
products. This is similar for Thailand, which has a large petrochemical sector.
India, according to Oil & Gas Journal, has the fifth largest refining capacity in
the world and Reliance Industries opened the largest oil refinery complex in the
world in 2009, so the figure is also likely to be higher than the actual domestic
consumption. Nonetheless, we estimate the oil price moving from US$80/barrel
to US$120 in recent months could impact GDP growth by 2 percentage points
across Asia.
2. Inflation. The direct inflationary impact of oil is not straightforward. Looking
simplistically at oil and food (for oil will ultimately drive food prices) impact is
misleading depending on the extent of subsidies and taxed within the oil price.
For example in China, oil prices are subsidised so a 10% increase in the oil price
may not directly feed through to inflation. In Korea, the fixed tax component on
gasoline means that a given rise in the oil price does not translate into the same
percentage change in gas prices. Nevertheless, Table 3 shows the food and oil
price weights in CPI baskets along with in the final column, the degree of oil
price control.
3. Budget and price controls. Given the subsidy that exists in a number of
countries, as we highlighted in Table 1, the impact of price controls means that
budget deficits are likely to increase in the current environment for many
economies. Clearly those most exposed is India, and this should also affect
Indonesia and China. Table 1 shows the amount of subsidies in % of GDP in
2008 and 2009 as a reference.
4. Current Account. Finally we show the current account and foreign reserves
for all countries in Table 1. Although most countries ex-Malaysia are very
vulnerable to rising oil prices and their impact on their current account balance,
India is the only country that is starting from the position of a current account
deficit. Granted, Indonesia’s current account surplus is low, but the positive
correlation between coal and oil should offer partial offset, given Indonesia is a
major coal exporter.
Taking this all together, India comes out worst, as most investors recognise,
with China and Indonesia also to some extent vulnerable, more on the inflation
side, with all countries ex-Malaysia probably equally vulnerable on the
consumption/growth side.
Moving beyond the direct economic impact to the more subjective impact on
markets, our view is that the most dangerous impact for Asian equities is likely
to come from the inflationary angle.
Back in May 2008 when the oil price spiked to US$150, the world was
awkwardly muddling through a contagious liquidity crisis, culminating in
September and October of that year. But liquidity was tight, especially after
Bear Stearns was rescued early in the year. The result of this was that current
account deficits were a major issue for markets – these being the easiest way to
think about vulnerability to liquidity conditions. Running one raises the
dependence on foreign capital.
This time we don’t think the current account situation is either as bad as in 2008
– only India is running one now – but more importantly, we don’t think this is
they key issue. This time, it’s inflation and the more direct growth impact that
are in our mind the key risk factors.
We’ve shown in Table 2, the simplistic impact of various oil prices, assuming
consumption volume doesn’t change, on GDP across the region. All countries
would be hit – to varying degrees this might show up in either fiscal deficits
worsening, or private consumption worsening (depending on the level of
subsidies). This is not factored into earnings, in our opinion. Neither the likely
lower revenue growth as GDP is hit by the rise in oil prices and consumption
reigned in, nor the impact on earnings from a spike in oil prices (Table 4 below
shows the various costs, country by country).
The other market issue in our view is inflation and its impact. We have
consistently believed that Asia’s monetary policy is too loose but so long as it
remains loose, these monetary arrangements are likely to be very positive for
asset prices. Until that is, that the monetary music stops, and policy is tightened.
As we’ve written about many times before, at some point we think it likely that
inflation will get sufficiently high for governments to allow their central banks
to tighten policy, abandon their hard or soft dollar pegs and allow FX
appreciation and higher rates to deal with the inflation threat. Until inflation is
perceived to be a major problem, we doubt this will happen, given most Asian
economies long-standing preference for export competitiveness.
Of late, the pick up in inflation across the region has worried many investors,
ourselves included. This is not because it is especially high, but because if it
does not turn out to be merely a cyclical issue resulting mainly from high food
prices due to bad weather but is something more pernicious, we may be sitting at
the edge of far tighter policy and much lower growth, with the risk of hard
landings within the region (especially China).
Very loose monetary policy, strong growth, weather driven food shocks. It is
much less likely that inflation would stabilise in the current situation if a
prolonged oil shock was thrown into this scenario.
Where does this cause us the greatest fear? We would be most concerned about
this in China, India and Indonesia. In China, because the credit expansion has
been greatest there since 2008 – the risk of tight policy after the credit expansion
of the last two years looks greater to us than elsewhere. We have been very
bullish on the China banks as we think they are most likely to rally most in the
event that inflation moderates and tight monetary policy risks recede (i.e. that
hard-landing fears lessen). On the positive side, oil prices will probably have
less direct impact on Chinese CPI due to price caps.
India too is considered vulnerable – we also tend to think that Indian inflation is
likely to moderate in the coming months as in China, mainly because monetary
conditions have become very tight there and the economy is slowing rather
quickly. As inflation stabilises and the economy slows, we expect the very tight
liquidity conditions in the financial markets to ease. These however are
vulnerable in the event of a further oil price shock. Again, the direct impact on
inflation, like China, is mitigated by price caps (albeit that diesel price reform
last June lessens these). The flip side of these however, is that the fiscal position,
already weak with reference to the rest of the region, is likely to take the strain
in terms of subsidies rising. This in turn worsens potentially already tight money
markets through crowding out private sector liquidity.
Indonesia is also at risk in our view, given rising headline (and in our view,
core) inflation pressures. Bank Indonesia has been one of the least aggressive
central banks in the region, in terms of tackling the pick up in inflation over the
last year, partly because they believe that core inflation will not be troubled too
much by what they consider temporary headline pressures. This may be put to
the test if oil prices remain high.
These to our mind are the three most vulnerable markets, when it comes to the
risks of oil prices spiking much further and inflation is the key issue to think
about.
3. Past precedents – the summer of 1990
Looking beyond our subjective thoughts on inflation, we turn to more objective
measures. What has happened when we’ve been through oil shocks in the past –
to the market, to valuations, to earnings and to leading indicators?
There have been many oil shocks over the last 40 years – the oil embargo of
1973, the Iran/Iraq war, the Iraqi invasion of Kuwait in 1990, the tension leading
up to the invasion of Iraq in 2003, and of course more recently the spike in oil to
US$150 in May 2008. Analysis of all of them carries specific challenges.
The first of these challenges is having data – we can’t analyse earnings changes
before 1988, as IBES data doesn’t go back beyond this. That unfortunately rules
out an analysis of both of the 1970s events, even though their ‘shock’ value in
terms of real oil price moves is probably more akin to today, along with 2008.
The challenge with 2003’s move is that is comes at the end of credit crunch
(when corporate bond spreads spiked in late 2002 and Chairman Bernanke was
rather presciently talking about the risks of Japanese deflationary effects
happening in the US) and in Asia, SARS. Disaggregating the impact of the oil
price move into the Gulf war is confused by these other events. Likewise, trying
to identify how much of Asia’s earnings fall in 2008 was due to the oil price
moving from US$ 100 to US$150 and how much was due to the financial crisis
and recession is not clear.
We’ve therefore restricted our analysis to 1990. Straight up, the problem here is
that spike in oil prices impact GDP by no more than a couple of hundred basis
points (using Duncan’s estimates). This would be equivalent today to a rough
‘shock’ of the Brent crude oil price going up to US$125/barrel Nevertheless, it
probably provides the cleanest comparison, in the absence of financial crisis or
recession clouding the picture.
At that time, growth in the rest of the world was weak-ish, with leading
indicators fading and interest rates being cut. And then on the first of August,
Iraq invaded Kuwait, and between then and mid October, the oil price more than
doubled from 20 to 40 (it peaked at this level on October 15). This was a real
shock – supply driven. And it was happening at a time without a financial crisis
or global recession to speak of (though it caused the latter). So how did Asian
equities perform, what happened to valuations and to earnings? The panel chart
7 shows 1990 in pictures.
As the oil price spiked in early August, Asian equities tumbled. The MSCI Asia
ex Japan index fall 29% until its trough in mid October.
Valuations at the start of this were not at elevated levels in terms of price/book
(in fact very low), and were slightly lower than current levels of P/forward
earnings (11.6x as opposed to 11.9x today). The point being that markets were
not exactly expensive into this fall. Similar to today.
Earnings fell – the 12 month forward earnings fell by 20% during the period.
The fall in earnings was a lot less than the fall in indices, but this probably
reflects the fact that analysts have a tendency to be slow to cut earnings. The
ultimate cost of the spike in oil prices was that a recession ensued, and earnings
came down further, albeit that the equity market looked through the subsequent
decline in earnings.
4. Sectors
Oil & gas
We start with the obvious beneficiary of an upward move in the oil prices – the
Oil & Gas sector. At present, the sector is trading near the peak of its market
relative PE since 2000, and on a PB basis near its average since 2003, when the
increase in the oil price started to gather steam. Purely on valuations, the sector
does not appear particularly attractive.
At the stock level, however, the impact from the oil price on individual
companies varies, depending on whether the companies have downstream
operations and if there is effective pass-through of changes in crude oil cost.
With the help of the Oil & Gas research team, we provide a quick overview of
the sensitivity in this section.
We look at this from two angles. First, the historical share price correlation with
the Brent crude oil price, shown in Table 7. Most stocks have historical had
positive correlation, which is a function of both their underlying sensitivity to oil
as well as to economic growth, which tends to be strong when the oil price is
rising. The actual correlation varies significantly depending on whether the
company operates upstream and downstream businesses (not surprisingly
CNOOC and Cairn India show the strongest positive correlation) and the
regulatory regime in which the companies operate. In the cases of the refiners, it
also depends on the time period and the industry supply & demand conditions at
the time.
We also show where the stocks are trading in terms of their current PB and the
sector-relative PB versus history on the same table. The stocks that look the
most interesting are the one with high positive correlation to the oil price and
trading at low valuations, or vice versa. From that perspective, PetroChina ‘H’
and PTT look like the most interesting stocks that benefit from higher oil price,
given that their current sector-relative PB are below the long-term averages.
We also look at the correlation in terms of fundamental earnings. Based on
estimates from our Oil & Gas team, CNOOC is the most sensitive to the oil
price within China due to its primarily upstream exposure. Peter Gastreich, our
analyst, estimates that every US$10/barrel move in the crude oil price would
affect EPS by 14%. PetroChina has more downstream exposure but EPS would
still be affected by 10% for every US$10/barrel oil price move.
In India, most of the Oil & Gas companies would actually see neutral or
negative impact if the oil price were to rise, due to the regulatory regime. We
believe the key beneficiary of higher oil prices is Cairn India, which is an
upstream company and does not pay subsidies (though near-term the uncertainty
surrounding the Cairn-Vedanta deal is likely to be the key share price driver).
The impact to Reliance Industries, Oil & Natural Gas Corporation and Essar Oil
would be broadly neutral; whereas Indian Oil Corp, Bharat Petroleum and
Hindustan Petroleum would be negatively impacted.
Across the rest of the region, the other beneficiaries include Medco Energi and
Energi Mega Persada in Indonesia, Petronas in Malaysia and the PTT group of
companies in Thailand. Piyanan Panichkul, our Thai Oil & Gas analyst,
estimates that (all else being equal) for every US$10/barrel move in the oil price,
the EPS for PTT Chemical would move by 23%, for PTT E&P, 13% and for
PTT Public, 10%.
Other sectors
For sectors outside of Oil & Gas, we look at how earnings behaved historically
during an oil shock. What we are after is how earnings react to a sharp change
in the oil price in a relatively stable economic environment. For this we again
turn to the 1990 episode as the ‘cleanest’ comparison with today.
Table 8 below shows the simple average of the change in earnings for Asia ex
Japan and the US when the oil price changed the most during the First Gulf War.
We include the US data because the Asia data is skewed by a very limited
number of data points. To us, the US earnings sensitivity looks more sensible
even though the company drivers could well be different from Asia
Not surprisingly, cyclical sectors such as Autos and Media were the most
negatively affected; whereas defensive sectors are the least sensitive. We
combine this ranking of sectors with the ranking for country vulnerability to the
oil price to produce a version of our ‘heat map’ in Table 9, from the least
sensitive in the top left corner to the most sensitive in the bottom right corner.
In each box, we show the current PB for the country industry groups and the
colour coding represents whether they are cheap or expensive on a marketrelative
basis, compared with history. The industry groups in red are the most
expensive; the ones in blue are the cheapest.
The sectors that look the most vulnerable from a rise in the oil price include the
Auto stocks, particularly the Korean auto companies given their earnings are
sensitive to demand in the developed markets. The Chinese, Indian and
Malaysian auto stocks appear slightly less sensitive as they sell primarily to the
domestic markets where the fuel prices are controlled by the government.
Other sectors that stand out are the Korean and Taiwan Transport sectors, both
of which are trading at high PB relative to history. The airlines look particularly
sensitive whereas fuel constitutes a smaller percentage of the costs for the
shipping companies.
The Thai consumer discretionary sectors (Consumer Durables/Apparel and
Media) also look expensive relative to history, and to the wider regional sector.
5. Stocks
In Table 10 below, we include a section from our note, Anomalies from the rise
in commodities dated 25 January 2011, in which we look at the impact from
movement in prices of various commodities, stock-by-stock. We have included
a summary table on Oil. Interested readers could refer to the full note for the
stock impact from agricultural commodities, amongst others, which would also
be affected by higher oil prices.
Summary of our Strategy View
We remain positive on Asia ex-Japan equities in 2011. Earnings growth
forecasts look achievable and valuations look attractive, especially relative to
other assets. With liquidity now becoming a tailwind, growth less of a concern
and the domestic credit cycle set to improve, we think Asia could re-rate from
its current discount to its historical average PE, and potentially even a premium.
Our 2011 year-end MSCI Asia ex-Japan index target is 670, based on 13.7x
forward PE, in line with the long-term average.
The combination of what we expect to be peaking leading indicators in the
coming months allied with reasonably firm relative valuations leaves little left in
the tank in our view for what was essentially a ‘macro’ trade that started last
November: the ‘exporter trade’ looks to be largely behind us. Our key country
picks are Singapore, China and Thailand - we have few macro fears here,
earnings and valuations look attractive, and weakness due largely to foreign
selling looks unwarranted relative to macro issues. We cut Korea and Taiwan to
underweight - cyclicals in general and Taiwan and Korea have tended to
struggle in relative terms after leading indicators peaked - whilst the absolute
valuations are not yet ‘expensive’, relative to the rest of Asia the PB is back to
near peak levels since 2003. We raise Indonesia to Neutral - bond yields have
moved higher with inflation fears. At the sector level, we are overweight
financials, as the best proxy for the liquidity theme and the credit cycle. We are
underweight defensive sectors, expecting them to underperform a rising market.
We believe there is an elevated risk that Asian markets could reach a ‘euphoric’
state, fuelled by inappropriately loose monetary policy. On the downside,
inflation, sharply higher US bond yields and government intervention are risks.
Table 11: Country Sector Weights
Overweight Neutral Underweight
China Hong Kong Korea
Singapore Indonesia Taiwan
Thailand India Philippines
Malaysia
Financials Information Tech Utilities
Consumer Disc. Telecom
Industrial Consumer Staples
Energy Health Care
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
UBS Investment Research
Asia Equity Strategy
How to think about oil and Asian equities
�� A framework to think about oil shocks
This note offers a framework of how oil shocks affect Asian equities and not a
prediction of the oil price (our global team forecasts a 2011 average of US$85/bbl
on fundamentals). Not surprisingly, Asia tends to underperform as a net importer.
�� India the most vulnerable to an oil shock; Malaysia the least
From a macro perspective, higher oil prices have implications on: 1) growth; 2)
inflation; 3) budget balances; and 4) the currency. The countries that are
considered to be most at risk are those that already face the greater inflation and
current account pressures. On these metrics India looks the most vulnerable;
Indonesia and China look somewhat at risk; and Malaysia looks the least affected.
�� What happened during the oil shock around the First Gulf War?
This period offers the cleanest comparison of an oil shock (pre-recession/financial
crisis). Between Aug and Oct 1990, the oil price doubled from US$20 to US$40
(which as a drag on consumption we think is equivalent to US$125 Brent crude
today), and Asian markets fell by 29% whilst 12M forward earnings fell by 20%.
This happened against a backdrop of modest valuations at 11.6x PE and 1.6x PB.
�� Prefer PetroChina H; Autos, Korea/Taiwan Transport relatively expensive
The Energy sector should be a beneficiary of higher oil prices but valuations do not
look particularly attractive – PetroChina is our Oil team’s top pick. Autos, Korea
and Taiwan Transport are sensitive to oil and look expensive versus history, based
on market-relative PB. In the last section, we have reproduced the oil section of our
detailed note on commodities ‘Anomalies from the rise in commodities’, dated 25
Jan 2011.
Unsurprisingly, we’ve been getting many questions about the impact of rising
oil prices on Asian equities. That’s what we cover in this note. Our sense is that
investors are nervous about this precisely because it is difficult to predict: the
very uncertainty of events in North Africa and the Middle East means risk
premiums are vulnerable – when events are deeply uncertain, risk premiums
typically rise, not fall. Larry Hatheway, our global asset allocation strategist, has
published a note to reduce risk assets weightings yesterday (‘Tactical risk
reduction’ 24 February 2011). At the same time we also suspect that (like us)
most investors are hoping that oil prices recede – in other words positioning is
not set for a rapid and aggressive spike in oil prices from here.
This note is not an examination of events in the Middle East and North Africa.
Nor is it a prediction of where oil prices are likely to go – for reference our oil
team think that ex current events, the oil price if driven by fundamentals should
be at US$85/barrel.
The purpose of this note is to provide a framework for thinking about oil spikes.
In this note we 1) look at past correlations between Asia and the oil price 2)
address the economic implications on growth, inflation, fiscal balances, trade
balances and as a result policy responses, with the help of our economics team
3) look back at the oil shock in August 1990 from Iraq’s invasion of Kuwait (we
explain why we have taken this episode, slightly later) both in terms of earnings
and performance, 4) examine the impact on the oil sector itself, but also which
sectors within countries look vulnerable and expensive (PetroChina ‘H’ is our
Oil team’s preferred pick; Autos, Korea/Taiwan Transport look relative
expensive on a PB basis) 5) we reproduce the oil section of our note from 25
January 2011 “Anomalies from the rise in commodities” where we looked at the
specific impact of rising commodity prices on individual stocks.
1. Asia Ex Japan’s relative performance vulnerability
First up – Asia ex Japan’s relative performance during oil spikes. Asia tends to
underperform other emerging markets, and the world index when the oil price is
rising. This is hardly a surprise as the oil price is simply a transfer payment
mechanism with Asia a net importer of oil.
At a relative level, Charts 4-6 shows the performance of Malaysian equities to
the region, as the region’s only oil exporting economy – it tends to be the safe
haven historically in relative performance terms.
2. The macro angle
Going beyond this simplistic market performance analysis, and turning to the
macro impact, we would highlight our colleague Duncan Wooldridge’s more
detailed note on this yesterday, (‘Texas Tea and Asia – Who is Exposed?’ dated
24th February 2011).
We see four things to consider from moves in the oil prices. Firstly, the impact
on growth, secondly the impact on inflation, thirdly the impact on budget
balances and finally the impact on current accounts and therefore the potential
impact on the currency.
1. Growth. What differentiates the moves today is that we are experiencing a
potential supply shock, not a demand shock. The ability to withstand this is less
as a result. Looking at the growth impact and taking simplistic data on oil
consumption as a share of GDP, reveals that most countries in Asia ex Japan are
at similar levels of consumption – prima facie, we estimate growth would be
impacted in a similar fashion of around 50 basis points for every US$ 10 move
in oil prices.
The only country in the region where oil consumption as a percentage of GDP is
in double-digit is Singapore. This is somewhat misleading as Singapore is a
regional refining centre, so a lot of the oil is actually re-exported as refined
products. This is similar for Thailand, which has a large petrochemical sector.
India, according to Oil & Gas Journal, has the fifth largest refining capacity in
the world and Reliance Industries opened the largest oil refinery complex in the
world in 2009, so the figure is also likely to be higher than the actual domestic
consumption. Nonetheless, we estimate the oil price moving from US$80/barrel
to US$120 in recent months could impact GDP growth by 2 percentage points
across Asia.
2. Inflation. The direct inflationary impact of oil is not straightforward. Looking
simplistically at oil and food (for oil will ultimately drive food prices) impact is
misleading depending on the extent of subsidies and taxed within the oil price.
For example in China, oil prices are subsidised so a 10% increase in the oil price
may not directly feed through to inflation. In Korea, the fixed tax component on
gasoline means that a given rise in the oil price does not translate into the same
percentage change in gas prices. Nevertheless, Table 3 shows the food and oil
price weights in CPI baskets along with in the final column, the degree of oil
price control.
3. Budget and price controls. Given the subsidy that exists in a number of
countries, as we highlighted in Table 1, the impact of price controls means that
budget deficits are likely to increase in the current environment for many
economies. Clearly those most exposed is India, and this should also affect
Indonesia and China. Table 1 shows the amount of subsidies in % of GDP in
2008 and 2009 as a reference.
4. Current Account. Finally we show the current account and foreign reserves
for all countries in Table 1. Although most countries ex-Malaysia are very
vulnerable to rising oil prices and their impact on their current account balance,
India is the only country that is starting from the position of a current account
deficit. Granted, Indonesia’s current account surplus is low, but the positive
correlation between coal and oil should offer partial offset, given Indonesia is a
major coal exporter.
Taking this all together, India comes out worst, as most investors recognise,
with China and Indonesia also to some extent vulnerable, more on the inflation
side, with all countries ex-Malaysia probably equally vulnerable on the
consumption/growth side.
Moving beyond the direct economic impact to the more subjective impact on
markets, our view is that the most dangerous impact for Asian equities is likely
to come from the inflationary angle.
Back in May 2008 when the oil price spiked to US$150, the world was
awkwardly muddling through a contagious liquidity crisis, culminating in
September and October of that year. But liquidity was tight, especially after
Bear Stearns was rescued early in the year. The result of this was that current
account deficits were a major issue for markets – these being the easiest way to
think about vulnerability to liquidity conditions. Running one raises the
dependence on foreign capital.
This time we don’t think the current account situation is either as bad as in 2008
– only India is running one now – but more importantly, we don’t think this is
they key issue. This time, it’s inflation and the more direct growth impact that
are in our mind the key risk factors.
We’ve shown in Table 2, the simplistic impact of various oil prices, assuming
consumption volume doesn’t change, on GDP across the region. All countries
would be hit – to varying degrees this might show up in either fiscal deficits
worsening, or private consumption worsening (depending on the level of
subsidies). This is not factored into earnings, in our opinion. Neither the likely
lower revenue growth as GDP is hit by the rise in oil prices and consumption
reigned in, nor the impact on earnings from a spike in oil prices (Table 4 below
shows the various costs, country by country).
The other market issue in our view is inflation and its impact. We have
consistently believed that Asia’s monetary policy is too loose but so long as it
remains loose, these monetary arrangements are likely to be very positive for
asset prices. Until that is, that the monetary music stops, and policy is tightened.
As we’ve written about many times before, at some point we think it likely that
inflation will get sufficiently high for governments to allow their central banks
to tighten policy, abandon their hard or soft dollar pegs and allow FX
appreciation and higher rates to deal with the inflation threat. Until inflation is
perceived to be a major problem, we doubt this will happen, given most Asian
economies long-standing preference for export competitiveness.
Of late, the pick up in inflation across the region has worried many investors,
ourselves included. This is not because it is especially high, but because if it
does not turn out to be merely a cyclical issue resulting mainly from high food
prices due to bad weather but is something more pernicious, we may be sitting at
the edge of far tighter policy and much lower growth, with the risk of hard
landings within the region (especially China).
Very loose monetary policy, strong growth, weather driven food shocks. It is
much less likely that inflation would stabilise in the current situation if a
prolonged oil shock was thrown into this scenario.
Where does this cause us the greatest fear? We would be most concerned about
this in China, India and Indonesia. In China, because the credit expansion has
been greatest there since 2008 – the risk of tight policy after the credit expansion
of the last two years looks greater to us than elsewhere. We have been very
bullish on the China banks as we think they are most likely to rally most in the
event that inflation moderates and tight monetary policy risks recede (i.e. that
hard-landing fears lessen). On the positive side, oil prices will probably have
less direct impact on Chinese CPI due to price caps.
India too is considered vulnerable – we also tend to think that Indian inflation is
likely to moderate in the coming months as in China, mainly because monetary
conditions have become very tight there and the economy is slowing rather
quickly. As inflation stabilises and the economy slows, we expect the very tight
liquidity conditions in the financial markets to ease. These however are
vulnerable in the event of a further oil price shock. Again, the direct impact on
inflation, like China, is mitigated by price caps (albeit that diesel price reform
last June lessens these). The flip side of these however, is that the fiscal position,
already weak with reference to the rest of the region, is likely to take the strain
in terms of subsidies rising. This in turn worsens potentially already tight money
markets through crowding out private sector liquidity.
Indonesia is also at risk in our view, given rising headline (and in our view,
core) inflation pressures. Bank Indonesia has been one of the least aggressive
central banks in the region, in terms of tackling the pick up in inflation over the
last year, partly because they believe that core inflation will not be troubled too
much by what they consider temporary headline pressures. This may be put to
the test if oil prices remain high.
These to our mind are the three most vulnerable markets, when it comes to the
risks of oil prices spiking much further and inflation is the key issue to think
about.
3. Past precedents – the summer of 1990
Looking beyond our subjective thoughts on inflation, we turn to more objective
measures. What has happened when we’ve been through oil shocks in the past –
to the market, to valuations, to earnings and to leading indicators?
There have been many oil shocks over the last 40 years – the oil embargo of
1973, the Iran/Iraq war, the Iraqi invasion of Kuwait in 1990, the tension leading
up to the invasion of Iraq in 2003, and of course more recently the spike in oil to
US$150 in May 2008. Analysis of all of them carries specific challenges.
The first of these challenges is having data – we can’t analyse earnings changes
before 1988, as IBES data doesn’t go back beyond this. That unfortunately rules
out an analysis of both of the 1970s events, even though their ‘shock’ value in
terms of real oil price moves is probably more akin to today, along with 2008.
The challenge with 2003’s move is that is comes at the end of credit crunch
(when corporate bond spreads spiked in late 2002 and Chairman Bernanke was
rather presciently talking about the risks of Japanese deflationary effects
happening in the US) and in Asia, SARS. Disaggregating the impact of the oil
price move into the Gulf war is confused by these other events. Likewise, trying
to identify how much of Asia’s earnings fall in 2008 was due to the oil price
moving from US$ 100 to US$150 and how much was due to the financial crisis
and recession is not clear.
We’ve therefore restricted our analysis to 1990. Straight up, the problem here is
that spike in oil prices impact GDP by no more than a couple of hundred basis
points (using Duncan’s estimates). This would be equivalent today to a rough
‘shock’ of the Brent crude oil price going up to US$125/barrel Nevertheless, it
probably provides the cleanest comparison, in the absence of financial crisis or
recession clouding the picture.
At that time, growth in the rest of the world was weak-ish, with leading
indicators fading and interest rates being cut. And then on the first of August,
Iraq invaded Kuwait, and between then and mid October, the oil price more than
doubled from 20 to 40 (it peaked at this level on October 15). This was a real
shock – supply driven. And it was happening at a time without a financial crisis
or global recession to speak of (though it caused the latter). So how did Asian
equities perform, what happened to valuations and to earnings? The panel chart
7 shows 1990 in pictures.
As the oil price spiked in early August, Asian equities tumbled. The MSCI Asia
ex Japan index fall 29% until its trough in mid October.
Valuations at the start of this were not at elevated levels in terms of price/book
(in fact very low), and were slightly lower than current levels of P/forward
earnings (11.6x as opposed to 11.9x today). The point being that markets were
not exactly expensive into this fall. Similar to today.
Earnings fell – the 12 month forward earnings fell by 20% during the period.
The fall in earnings was a lot less than the fall in indices, but this probably
reflects the fact that analysts have a tendency to be slow to cut earnings. The
ultimate cost of the spike in oil prices was that a recession ensued, and earnings
came down further, albeit that the equity market looked through the subsequent
decline in earnings.
4. Sectors
Oil & gas
We start with the obvious beneficiary of an upward move in the oil prices – the
Oil & Gas sector. At present, the sector is trading near the peak of its market
relative PE since 2000, and on a PB basis near its average since 2003, when the
increase in the oil price started to gather steam. Purely on valuations, the sector
does not appear particularly attractive.
At the stock level, however, the impact from the oil price on individual
companies varies, depending on whether the companies have downstream
operations and if there is effective pass-through of changes in crude oil cost.
With the help of the Oil & Gas research team, we provide a quick overview of
the sensitivity in this section.
We look at this from two angles. First, the historical share price correlation with
the Brent crude oil price, shown in Table 7. Most stocks have historical had
positive correlation, which is a function of both their underlying sensitivity to oil
as well as to economic growth, which tends to be strong when the oil price is
rising. The actual correlation varies significantly depending on whether the
company operates upstream and downstream businesses (not surprisingly
CNOOC and Cairn India show the strongest positive correlation) and the
regulatory regime in which the companies operate. In the cases of the refiners, it
also depends on the time period and the industry supply & demand conditions at
the time.
We also show where the stocks are trading in terms of their current PB and the
sector-relative PB versus history on the same table. The stocks that look the
most interesting are the one with high positive correlation to the oil price and
trading at low valuations, or vice versa. From that perspective, PetroChina ‘H’
and PTT look like the most interesting stocks that benefit from higher oil price,
given that their current sector-relative PB are below the long-term averages.
We also look at the correlation in terms of fundamental earnings. Based on
estimates from our Oil & Gas team, CNOOC is the most sensitive to the oil
price within China due to its primarily upstream exposure. Peter Gastreich, our
analyst, estimates that every US$10/barrel move in the crude oil price would
affect EPS by 14%. PetroChina has more downstream exposure but EPS would
still be affected by 10% for every US$10/barrel oil price move.
In India, most of the Oil & Gas companies would actually see neutral or
negative impact if the oil price were to rise, due to the regulatory regime. We
believe the key beneficiary of higher oil prices is Cairn India, which is an
upstream company and does not pay subsidies (though near-term the uncertainty
surrounding the Cairn-Vedanta deal is likely to be the key share price driver).
The impact to Reliance Industries, Oil & Natural Gas Corporation and Essar Oil
would be broadly neutral; whereas Indian Oil Corp, Bharat Petroleum and
Hindustan Petroleum would be negatively impacted.
Across the rest of the region, the other beneficiaries include Medco Energi and
Energi Mega Persada in Indonesia, Petronas in Malaysia and the PTT group of
companies in Thailand. Piyanan Panichkul, our Thai Oil & Gas analyst,
estimates that (all else being equal) for every US$10/barrel move in the oil price,
the EPS for PTT Chemical would move by 23%, for PTT E&P, 13% and for
PTT Public, 10%.
Other sectors
For sectors outside of Oil & Gas, we look at how earnings behaved historically
during an oil shock. What we are after is how earnings react to a sharp change
in the oil price in a relatively stable economic environment. For this we again
turn to the 1990 episode as the ‘cleanest’ comparison with today.
Table 8 below shows the simple average of the change in earnings for Asia ex
Japan and the US when the oil price changed the most during the First Gulf War.
We include the US data because the Asia data is skewed by a very limited
number of data points. To us, the US earnings sensitivity looks more sensible
even though the company drivers could well be different from Asia
Not surprisingly, cyclical sectors such as Autos and Media were the most
negatively affected; whereas defensive sectors are the least sensitive. We
combine this ranking of sectors with the ranking for country vulnerability to the
oil price to produce a version of our ‘heat map’ in Table 9, from the least
sensitive in the top left corner to the most sensitive in the bottom right corner.
In each box, we show the current PB for the country industry groups and the
colour coding represents whether they are cheap or expensive on a marketrelative
basis, compared with history. The industry groups in red are the most
expensive; the ones in blue are the cheapest.
The sectors that look the most vulnerable from a rise in the oil price include the
Auto stocks, particularly the Korean auto companies given their earnings are
sensitive to demand in the developed markets. The Chinese, Indian and
Malaysian auto stocks appear slightly less sensitive as they sell primarily to the
domestic markets where the fuel prices are controlled by the government.
Other sectors that stand out are the Korean and Taiwan Transport sectors, both
of which are trading at high PB relative to history. The airlines look particularly
sensitive whereas fuel constitutes a smaller percentage of the costs for the
shipping companies.
The Thai consumer discretionary sectors (Consumer Durables/Apparel and
Media) also look expensive relative to history, and to the wider regional sector.
5. Stocks
In Table 10 below, we include a section from our note, Anomalies from the rise
in commodities dated 25 January 2011, in which we look at the impact from
movement in prices of various commodities, stock-by-stock. We have included
a summary table on Oil. Interested readers could refer to the full note for the
stock impact from agricultural commodities, amongst others, which would also
be affected by higher oil prices.
Summary of our Strategy View
We remain positive on Asia ex-Japan equities in 2011. Earnings growth
forecasts look achievable and valuations look attractive, especially relative to
other assets. With liquidity now becoming a tailwind, growth less of a concern
and the domestic credit cycle set to improve, we think Asia could re-rate from
its current discount to its historical average PE, and potentially even a premium.
Our 2011 year-end MSCI Asia ex-Japan index target is 670, based on 13.7x
forward PE, in line with the long-term average.
The combination of what we expect to be peaking leading indicators in the
coming months allied with reasonably firm relative valuations leaves little left in
the tank in our view for what was essentially a ‘macro’ trade that started last
November: the ‘exporter trade’ looks to be largely behind us. Our key country
picks are Singapore, China and Thailand - we have few macro fears here,
earnings and valuations look attractive, and weakness due largely to foreign
selling looks unwarranted relative to macro issues. We cut Korea and Taiwan to
underweight - cyclicals in general and Taiwan and Korea have tended to
struggle in relative terms after leading indicators peaked - whilst the absolute
valuations are not yet ‘expensive’, relative to the rest of Asia the PB is back to
near peak levels since 2003. We raise Indonesia to Neutral - bond yields have
moved higher with inflation fears. At the sector level, we are overweight
financials, as the best proxy for the liquidity theme and the credit cycle. We are
underweight defensive sectors, expecting them to underperform a rising market.
We believe there is an elevated risk that Asian markets could reach a ‘euphoric’
state, fuelled by inappropriately loose monetary policy. On the downside,
inflation, sharply higher US bond yields and government intervention are risks.
Table 11: Country Sector Weights
Overweight Neutral Underweight
China Hong Kong Korea
Singapore Indonesia Taiwan
Thailand India Philippines
Malaysia
Financials Information Tech Utilities
Consumer Disc. Telecom
Industrial Consumer Staples
Energy Health Care
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