Daniel Lian of Morgan Stanley: UK-Europe View of Southeast Asia

UK-Europe View of Southeast Asia
Daniel Lian (Singapore)

I spent the past week meeting more than two dozen global emerging market (GEM) and Asia-dedicated money (ADM) investors based in the UK-Europe. Below are several major topics/themes that we discussed:

(1) Overweight Southeast Asia relative to China and Northeast Asia: Most investors believe that, given uncertainty on the rate of Chinese growth and the lack of a proactive domestic demand policy response from Korean policymakers, the preferred emerging markets in Asia are the four Southeast Asian markets – Malaysia, Thailand, Indonesia and the Philippines. They also like Hong Kong and Singapore for their reflating domestic demand and stronger corporate governance and returns story.

(2) Easy money has been made and selection is becoming more stringent: Most investors recognize that the easy money has been made as the expansion of global demand from mid-2003 to mid-2004 made equities in global emerging markets an attractive investment proposition. However, investors are now slowly building varying degrees of weak global demand scenarios into their macro-portfolio decisions. Weak domestic demand almost invariably hurts global emerging market equities, particularly in Asia. This means investors will become increasingly selective, searching for either emerging economies that will provide domestic demand resilience or emerging markets that are experiencing other strong macro-micro restructuring positives.

(3) Southeast Asia has avoided the worst-case scenario: I discussed the subject of “Sino Hollow” – how much has China hollowed out Southeast Asia and how much more will it do so in future – with every fund manager I met (see “Sino Hollow”, October 7, 2004). They were impressed with Southeast Asia. Despite a decade (1994-2003) of Chinese attacks on its manufacturing sector, the region experienced a 49% accumulated increase in manufacturing output growth (vis-à-vis China’s 185%) with manufacturing output rising from 25.2% to 30.2% of its GDP. Concomitantly, Southeast Asia has preserved its 4.4% manufactured export share in the global merchandise market. While China’s manufacturing growth has outpaced that of Southeast Asia, there was a relative, but no absolute, hollowing out of Southeast Asian manufacturing.

While FDI trends suggest China is building up its manufacturing FDI substantially faster than Southeast Asia – China took in US$397 billion during 1994-2003 compared to Southeast Asia’s US$147 billion – there is increased evidence of a probable rise in urban Chinese manufacturing wages. The presence of structural reform in Southeast Asia means that it has avoided a worst-case scenario, i.e., a complete hollowing out of Southeast Asian manufacturing because of the rise of China and a lack of effective economic development strategy and positive political-economic reform.

(4) Structural upswing or mere cyclical spurt: Based on our conversations, investors see the need to distinguish between strong structural momentum and a mere cyclical spurt experienced by emerging economies. Structural momentum is attained through the removal of stubborn structural impediments – erroneous macroeconomic policy, or microeconomic inefficiency centered on the private corporate and state enterprise sectors. While some investors were skeptical, a large number we spoke to believe Thailand, in addition to Russia and Turkey, belongs to a confirmed group of restructuring GEM regimes where strong policymakers aggressively pursue removal of structural impediments to produce tangible and sustainable macro-economic growth and micro-economic efficiency gains.

These are clearly distinguishable from temporary economic gains that are tied to a cyclical spurt. Other than Thailand, they also believe Malaysia and Indonesia possess the potential to be among the “restructuring” group.

(5) Investors we spoke to approve of the new economic strategy and positive political economy changes in Southeast Asia, but would be most cheered if a structural investment boom occurs: Investors observed that Thailand has shifted to a more balanced economic strategy, emphasizing “second track” activities in rural, grassroots, agriculture-resource, SME, tourism and other service sectors. They observe Malaysia is putting in considerable effort to do likewise and are hopeful that Indonesia and the Philippines will also unleash new economic strategies to better balance their growth path.

Political-economic change is another structural shift that has won approval from investors. Singapore has a new head of government, and Malaysia and Indonesia have elected new leaders. The Philippines has renewed Mrs. Arroyo’s mandate, and Thailand will soon hold elections. Investors observed that pro-active economic management and the search for new growth engines feature prominently in these Southeast Asian leaders’ platforms.

One of the key shifts investors desired was a structural lift in investment. Since the 1997-98 Asian Financial Crisis, the investment to GDP ratio has declined substantially in Southeast Asia, but in China it has expanded. Investors believe an investment-poor Southeast Asia can now sustain higher investment rates, whereas China should guide down its excessive investment in poor return domestic ventures. The weaker growth momentum in Southeast Asia in recent years has more to do with domestic investment sluggishness than with manufacturing and export weakness (Exhibit 3). As Southeast Asia has to varying degrees repaired its bruised balance sheet since the Asia Financial Crisis period, the region is ripe for a “managed” structural lift (avoiding unproductive assets) domestic investment boom.

(6) Further discussion of investment rationale for each Southeast Asia economy/market:

Singapore: Investors have enjoyed a strong cyclical upturn, with projected 8-9% growth in 2004 making Singapore the second fastest growing economy in Asia. There has been considerable upside surprise on the corporate front as a result of the government’s restructuring efforts and improved corporate governance, which has resulted in greater corporate transparency and a steady rise in dividend yield and asset turnover.

While some investors believe the recent rise in domestic demand, consumer spending and loan growth could be sustained for longer, most agree that Singapore is a high beta Asian economy that is heavily dependent on global demand. If a dramatic slowdown in global demand were to occur in 2005, Singapore’s cyclical spurt would end. However, investors saw good prospects of micro economic and corporate efficiency gains (resulting from ongoing government-linked enterprise restructuring and its emphasis on economic efficiency), which continue to underpin the Singapore market.

Malaysia: Investors generally approved of the Badawi government and his efforts to dismantle the rent-seeking complex and diversify the Malaysian economy. However, while some expected a continued lift in Malaysia’s domestic demand, most investors believed that Malaysia, like Singapore, is a high beta economy that is highly geared towards global demand. They cited the existence of a sophisticated urban consumer culture (households are already quite geared), the strong dependence of the Malaysian economy on exports, the lack of fiscal latitude, and the uncertainty of a structural private investment upswing as evidence for this. However, because of the government’s considerable ownership of the corporate economy and its declared intention to implement corporate restructuring, we believe that Malaysia, like Singapore, could offer considerable micro efficiency gains.

Thailand: A minority of investors believed Thaksinomics has come to a dead-end, that Thai output potential is limited and that in future the economy would cease to outperform other global emerging economies. They also attribute the damage to the Thai economy from unforeseen circumstances (such as avian flu, Southern unrest and substantial oil price hikes) to Mr. Thaksin. However, the majority believe there is room for the Thai economy to grow and that if Mr. Thaksin were to be re-elected and if he continues with his dual-track policy and the “third chapter” of expanding aggregate supply potential, then the structural upswing will have a strong second leg. They see the present low forward price-earnings ratios as a good opportunity to go long on Thai equities. Investors we spoke to also generally agreed that in times of weakening global demand, Thailand would outperform most of its global and Asian emerging economic peers.

Indonesia: Most investors agreed that, in terms of a shift in economic development strategy and positive political economy change, Indonesia has substantial upside. They believed that, given Indonesia’s underdeveloped rural and grass-roots economies, as well as its significant resources and underdeveloped SME sector, it has strong prospects to strengthen its “second track” economy. They were also hopeful that the incoming President Yudhoyono would cripple the rent-seeking complex and install effective and competitive economic leadership.

The Philippines: Investors were still skeptical about the long-term restructuring prospects of the Philippines economy. President Arroyo has a fresh mandate and is likely to secure a “first round” victory in her efforts to diversify and enlarge the tax base, as well as improving tax collection. However, investors are fundamentally skeptical about her ability to tackle the larger issues facing the country’s politics and economy.

Bottom Line: Southeast Asia Has Avoided the Worst Case Scenario

In the past year, UK/Europe investors have raised their exposure to Southeast Asia’s emerging markets – Malaysia, Thailand, Indonesia and the Philippines – in preference to China and Korea, as they seek shelter from the slowdown in China’s economy and the lack of proactive Korean domestic demand policy. They also like Hong Kong and Singapore for their reflating domestic demand and stronger corporate governance and returns stories. However, investors are building weakening global demand into their portfolio assumptions and are either searching for emerging economies that will provide domestic demand resilience or other strong macro-micro restructuring positives.

We believe Southeast Asia has increased potential to fit into the above bill of domestic demand resilience and strong restructuring positives. Investors are also beginning to believe that Southeast Asia has avoided the worst case scenario (a complete hollowing out of Southeast Asian manufacturing because of the rise of China and a lack of effective economic development strategy and positive political-economic reform) as the region succeeds in preserving its global share of manufactured exports and begins to embrace economic diversification and positive political-economy reform.

Investors are distinguishing between structural upswings and mere cyclical spurts. Most see Thailand, in addition to Russia and Turkey, as belonging to a confirmed group of restructuring GEM regimes where strong policymakers aggressively pursue removal of structural impediments and produce sustainable macro-economic growth and micro-economic efficiency gains. They believe Malaysia and Indonesia could become members of the “restructuring” group.

While the new economic strategy shift and positive political-economy changes in Southeast Asia have won investor approval, investors would be further cheered if Southeast Asia were to embark on a structural lift in domestic investment. In my view, Thailand’s Prime Minister Thaksin’s plan to aggressively expand aggregate supply potential in the next few years means that Thailand, among Southeast Asian economies, has the greatest certainty of delivering a structural domestic investment boom to investors.