Editor’s note: Asia is the second stop in a seven-part tour of each continent’s economic and market outlook, including the impact on U.S. stocks from international exposure. Read about Europe.
A bull market is raging across Asia in 2015. But before investors jump on the trend, it’s critical to understand the dynamic risks and rewards of this large and diverse region.
One of this year’s biggest stories is the booming bull market in China—a charge that sputtered in June. In the first six months of the year, the Shanghai Composite Index gained about 50%. But these remarkable gains in the Chinese stock market coincided with a dramatic slowing in the economy, and as summer hit, stock market cracks were apparent.
After more than a week of a brutal sell-off in Chinese stocks, the country’s central bank took a rare easing step in late June, cutting both its benchmark interest rates and the amount of reserves certain banks are required to hold. The action followed a 20% haircut for China’s Shanghai Composite Index since hitting its highest level after the financial crisis as recently as June 12. The decline took root first in startup stocks, which shed a quarter of their value since hitting record highs as a group earlier this month.
According to the World Bank, China’s gross domestic product (GDP) grew by 7.4% in 2014—its slowest pace in 24 years. China’s GDP is forecast to fall to 7.1% this year and 7.0% next year. Some analysts find these forecasts optimistic because Q1 2015 GDP already came in light of estimates at 7.0% and May inflation fell to 1.2%—one sign that consumers are saving instead of spending.
Loosening Markets and Policy
Along with the continuing recovery in the global economy since the financial crisis, there are two big drivers of the bull market in China. The first is massive stimulus by the Chinese government. The government plans to spend more than $1 trillion USD on infrastructure projects this year. And the central bank has cut interest rates four times since November 2014, including that “emergency” action in June.
The second driver behind China’s bull market was a major change to the structure of the Chinese market last year. On November 17, 2014, regulators launched the “Stock Connect” between the Shanghai and Hong Kong stock exchanges. This program enabled mainland Chinese investors to purchase stocks in Hong Kong and foreign investors around the world to purchase mainland China shares, also known as “A-shares.” There were significant restrictions for both mainland Chinese investors and foreign investors before Stock Connect. But since its debut, investors have plowed money into the mainland market.
The divergence between the Chinese economy and stock market has many investors worried about a speculative bubble. The worries are well founded, considering the massive debt the Chinese government is taking on to stimulate the economy. According to McKinsey & Company, China’s debt is now in excess of 280% of GDP. This degree of leverage is worrisome, particularly if the economy doesn’t respond to recent stimulus.
Although China has produced some world-class companies like Alibaba (BABA), Baidu (BIDU), and Sohu (SOHU), many of its companies need high growth rates to survive. This is why alarm bells are sounding with GDP slipping to 7% amid a mountain of debt. Despite these worries, the all-powerful investor psychology in China is as bullish as it’s ever been. And there’s still room to run for Chinese stocks. The Shanghai Composite reached 5000 earlier this summer, which is still 1000 points below the high of 6000 reached in 2007.
Japan Shakes Off Recession
While 7% GDP growth is reason for worry in China, a comparatively modest 2.4% growth rate in GDP in Japan is reason for stock bulls to celebrate. Japan logged this growth rate in Q1, which helped the Japanese stock market achieve a respectable gain compared with other developed markets in the first half of the year.
Japanese growth was a positive surprise and helped the world’s third largest economy emerge from its most recent recession last year. Recession after recession has plagued the Japanese economy for decades as the government battled deflation and structural issues, including an aging society.
Deflation is a general decrease in prices of goods and services. It’s bad because if a consumer senses the price of a widget will be lower in the future, she won’t buy it today. The profit margin of the company that makes widgets shrinks, and the company doesn’t hire. Deflation becomes a self-reinforcing system that spirals lower.
Look no further than Japan’s Nikkei 225 to see the downward spiral. The Nikkei 225 reached a high of about 38,900 in 1989. About 25 years later, the Nikkei 225 is still roughly 50% below its all-time high.
The rally in the past year clearly marked the first significant “higher high” since the late ’80s. With hindsight, it’s easy to understand that last year’s rally was in anticipation of this year’s much-better-than-expected GDP growth.
The big risk in Japan is the percolating global interest rate market. The Bank of Japan—like all of its counterparts who’ve applied quantitative easing (QE) to juice their respective economies—wants low rates and a weak currency in order to boost its largely export-dependent economy. But the global bond market may be pushing back a bit given this year’s volatility in yields. A breakout in the yield of Japanese government bonds could trigger a deeper pullback in the Nikkei 225, if history is any guide.
Good Morning, Vietnam!
One reason Japan suffered deflation was because the country’s populace skewed older. Older people generally receive entitlements like social security, which is a problem when fewer young people are paying into a system from which more people are withdrawing. Older people also tend to spend less. They don’t generate as much economic activity as, say, a 45-year-old raising three children in a home with a backyard, commuting to and from work, buying work clothes, and eating out for lunch.
Figure 3 shows Japan’s population pyramid by age ranges and sex. Males are on the left and females on the right. See the large horizontal bars in the age ranges of 60–64 and 65–69? Next, check the bars for 30–34 and up. There are a lot more people in Japan who are over 30 than under.
Now take a look at Vietnam’s population pyramid (figure 4). Vietnam is young. There aren’t many older people receiving entitlements. There are a lot of people in their prime working age—people who need to buy clothes, cars, and houses.
Vietnam is considered a frontier market. Investors have to stick their necks out in terms of political and economic risk, as well as currency risk. The nation is still transitioning from a centrally planned economy, but progress is being made. According to the CIA World Factbook, “poverty has declined significantly, and Vietnam is working to create jobs to meet the challenge of a labor force that is growing by more than one million people every year.”
The demographic story in Vietnam is compelling, but it’s very much the long, long, long-term view. In the recent past, the Vietnam stock market has dramatically underperformed other markets across Asia, particularly China and Japan. In fact, it’s gone nowhere for the last four years. Bulls aren’t discouraged. The flat churn simply has some value investors taking a closer look at this frontier.
What’s clear is that Asian markets are at varying cycles economically, politically, and structurally. To uncover dynamic risks and rewards, it’s best to study each independently as well as how they relate within the continent and to the rest of the developed and developing world.