Is Asian shares market still safe?

Plenty of bubbles in glass of champagne but none in Asia

While some markets look a little expensive, a collective bubble it is not.
Could it become a bubble? Of course emerging markets, by their very nature, offer fertile ground for bubbles. They are, after all, emerging. Looking at Asia ex today and there are certainly aspects, negative real rates being one, which if left in place for too long will lead to a misallocation of capital. What all the questions regarding a bubble tell us, though, is that there remains a wall of worry. And as long as that is the case, markets will trend higher.

Casting away the cobwebs to recall the 1993, 1997, 2000 or 2007 market peaks, and there were fewer questions about bubbles than there are now.

Below we have looked at the question of Asia ex being in a bubble through evidence from valuations (there is none), the corporate balance sheet (not a bubble), the government balance sheet (no bubble there) via the loan-deposit ratio (LDR) for the banks (nothing here), equity issuance (not a bubble either), velocity of trading (can’t find it there either), degree of fund flows (nope) or vs prior bubbles both in terms of time and moves or valuations (no bubble there either).

Regional valuation: No bubble to be found
Most of you will be familiar with P/BV for the region ex Japan. Yes, we are above average (note too we don’t spend much time there, we have an average because we have a high and a low but significant it is not) but no, we are not anywhere near the prior peaks. As you can see, Asia ex does bubbles with a high degree of regularity.
After 35 years and four bubbles later, the debate recommences.

At present, Asia ex is on 2.2x P/BV, the horizontal line at 2.7x P/BV is the point at which we’d make the argument “looks like a bubble, smells like a bubble, feels like a bubble, it is a bubble”. Your risk reward at that point is 38% upside at most vs 58% downside if we have the usual downswing. Not a great risk reward. So even without growth in book value, with 9% compound growth per annum since 1975, Asian equities can rise 23% from here before investors should think about owning less of Asia, and markets can rise 36% before we are at three times book. The train has left the station but as yet has not arrived at the final destination.

Presently we are at mean P/E over the course of the last 35 years. Not below, not above, but at the mean. Market peaks range from the all-time high of 28 in 1993 to between 21x-25x. So, with the trailing P/E of 16.3 times, we are not yet at the prior peaks and, as such, to make the call that we are in a bubble is not only tough but also false. As such, region-wide there is no valuation bubble in Asia ex. What about individual countries or sectors?

Country by country, sector by sector
In terms of the individual countries, the only country that looks expensive on a P/BV basis is Indonesia, at 4.9x P/BV and average of 2.8x over the last 20 years (2.9x over the last ten years) and an all-time high of 6x.

As things stand, this leaves us 22% upside until the “this time it is different” debate starts. It’s not a cheap market — yes, ROE is high, but ROE investing has done little for investors’ P&L in Asia ex — but neither is it well and truly in bubble territory.

As for all the other markets, some are slightly above their averages but none would suggest “this is a bubble”.

Turning to sectors, this gives a very similar picture. The most expensive sector is the broad consumer space with a P/BV multiple of 3x. The peak since 1990 has been 3.4x: we have a further 13% upside before it is either the same or different. So, in terms of risk reward, one could say the valuations on a P/BV basis have reached levels that show a poor risk reward and have the hallmarks of a bubble.

The other sectors however show no signs of being in a bubble; banks can rise 50% from here to get to prior peaks, same for industrials, and real estate can actually double from here. As for Tech and Telecoms, well they can go up three-fold if (big if) they were to reach their prior peak valuations again. Given where valuations are on a sector basis, it is hard to make the call that we have a sector overvaluation bar in the consumer space. Everywhere else we are either at the mean or slightly above mean.

The corporate, government balance sheet and the ability to lend
For there to be a bubble, some one/something has to leverage up. Bubbles need leverage in order to inflate. It is the leverage, which allows valuations to get really out of hand. You also need capital to not only be available, but it also has to be so at a price, which is affordable. The latter two conditions are certainly there, as five out of 10 economies in Asia ex have negative real interest rates, a further four have less than 100 bps and that with 6- 10%+ nominal GDP growth.

The question is, though, where are we in that cycle? For net debt to equity we can go back to the early 1980s.

Historically, we have had a deleveraging cycle and a re-leveraging cycle, depending on the growth outlook. Since 1997, all we’ve had is a de-leveraging cycle regardless of what has been going on with the real economy.

Based on 2011 forecasts, net debt to equity in Asia ex will be the lowest since 1981 if forecasts prove correct. Given where interest rates, ROE and debt is, there is a good chance that gearing rises again over this cycle rather than falling further.

Given the economic growth rates and interest rate levels, debt to GDP in the mid-50% range is easily sustainable. So again, it’s hard to make a call that the government balance sheet is an accident waiting to happen, according to the data from our economic team.


Banks and their ability to lend:
The LDR in the Asian banking system. At present, the LDR for Asia ex stands at 0.72. At its peak in the mid-1990s it stood at close to one. As we know full well, there is nothing quite like a bull market to convince people that they are geniuses, that there are no risks and more leverage is better than less. When the banking sector is lent-out and no new credit available, so the music stops. We are quite some way off that point. Yes, the LDR in Korea is above one but it is falling. In the case of Indonesia, some banks also have an LDR above one and Salman, our Indonesian banking analyst, has a sell on those with LDRs above one. Regionwide however, we are quite some way off even approaching the LDR of one. No bubble here as yet.

Everyone loves Asia ex, right?
Sure, flows into GEMS and Asia ex have been very strong this year (see Kelly Kwok’s Fun with Flows product), but are they in bubble territory? The risk is that we look only at the absolute levels and, yes, at US$17 billion (RM54 billion), these are big, but what about relative to either AUM or market cap?

Cumulative flows as a percentage of market cap remain very small and are a long way off the level in 1993 and the peak in 2000. So, flows have been good but not to the point that you’d say, big room full of people with a small door. No bubble here either.

I’ll show you bubbles!
Robert Buckland and the global strategy team. Have done a bubble montage two ways: one is in terms of the price performance and the second from a valuation basis. Asia ex is on slightly over two times P/BV and peaked at 3x in the last cycle.

Turning to Figure 2, the duration. Bubbles take time to inflate and insufficient time has gone past between the start of this one and where we are today.

The China bubble of the early 2000s took over 200 days, the India run of the early 2000s took 300 days, and so on.

With the exception of the Japanese bubble, all peaks are preceded by a sudden sharp move, the parabolic phase.

Could there be one?
Of course there could. Weak growth in G3 with very low interest rates makes this part of the world look very attractive. Positive growth differentials bring with them fund flows. With five out of 10 economies enjoying negative real interest rates and a further four less than 100 bps of real rates, misallocation of capital is a given.

But, and this is important, for it to get really out of hand it needs to be left in place for a period of time, longer than what we’ve had thus far.

So yes, it could happen and has happened four times over the last 35 years and, though I don’t usually gamble, I am willing to wager that we will see a fifth one by the time we have 40 years worth of data.

Our year-end 2011 forecast remains unchanged at 695 on MXASJ, and that’s 22% upside from here.


This article appeared in The Edge Financial Daily, November 18, 2010.