Enjoying the View as Asian Markets Rally From the Doldrums

The performance of the Asia ex-Japan equity universe is reaching a level where many investment professionals will be happy to cash in their bets and retire for the rest of the year. A return of 45% in dollar terms in the year to 23 June should have met most investors' expectations at the start of the year, especially following the explosive rally in the fourth quarter of 1998.

Asia ex-Japan is now outperforming all the equity universes by a large margin, including the U.S. Internet stocks. Despite this, it remains premature to raise cash in the asset allocation. There is still a wall of worry to climb. Global money has yet really to be allocated back to Asia ex-Japan. When that happens it has the potential to cause every market in the region to double again, given the small size of these markets relative to bloated valuations in the U.S. It is certainly hard to see where a problem is going to come from to smash market sentiment in the short term. A 25-basis-point hike in the federal funds rate is already discounted. Indeed it would probably be bearish if the Fed failed to tighten, since that would likely send U.S. bond yields higher.

Meanwhile, sentiment toward Asia remains skeptical. Paul Krugman is on the cover of Time warning about the sustainability of the Asian recovery. While such scepticism is understandable, Greed & Fear would question Krugman's assertion that none of the vulnerabilities that created the Asian crisis have disappeared. There clearly has been a significant change in Asia, most particularly in government policy. To state otherwise is to believe no lessons have been learned, which is as wrong as it is deeply patronizing.

Taiwan and Singapore provide examples of two governments that have made clear decisions to improve the competitiveness of their banking systems even though neither country suffered a banking crisis. This shows the best type of proactive policy making. Clearly in those countries that did suffer banking crises, doors are being opened to foreign ownership. That should improve credit allocation in the future.

Ultimately, however, markets run on liquidity and sentiment. Both continue to go Asia's way for now. The proof of how positive sentiment is came in the Hang Seng's enthusiastic response to the Hong Kong government's proposal to deal with its HK$220 billion stock portfolio via the establishment of a mutual fund, index-linked to the Hang Seng.

The market's reaction shows that it is desperate to celebrate any sign that the stock overhang will be removed -- even though it could be argued that if the government sells a mutual fund it will be offset by smaller sales of private-sector mutual funds. The market's reaction is doubly persuasive of the extent of bullish sentiment, considering that Hong Kong has the worst short-term fundamentals of all the Asian ex-Japan markets given the high level of real interest rates and the lack of an exchange-rate adjustment.

The surge in trading volumes in China's domestic A- and B-share stock markets following the latest interest rate cut should also not be ignored. Average daily turnover of China's A-share market rose 355% to 33.5 billion renminbi in June from 7.4 billion renminbi in the first five months this year. B-share market average daily turnover increased by 846% to $54 million in June from an average of $5.7 million between January and May.

China may be the biggest remaining problem in Asia, but the ultimate fallout there may turn out to be a 2000 event, rather than a 1999 one. It is now official policy in Beijing to boost the local stock markets again just as it was during the red-chip fever in the summer of 1997. More gains in China-related equities are likely, given there is still scope for the PBOC to cut interest rates. China's real rate of interest for bank loans remains over 8%, which is too high to stimulate recovery. Further interest-rate cuts are therefore needed, but the policy course clearly threatens intensified capital flight and renminbi devaluation. Greed & Fear's view is that despite the exchange-rate concern, the Chinese authorities will decide that domestic deflation is the greater menace. That means China's interest rates will follow Japan's on the way to zero. That, in the short to medium term at least, will keep everybody bullish.

Enjoy the game while it lasts as Greed & Fear will, as this is written from a balcony Somerset Maugham would not have been so happy to sit on in this egalitarian age of hotels designed for the masses. The view, however, more than compensates...

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