Churchouse Letter
May 2010                   by Peter Churchouse

Once Bitten, Twice Shy – The Asian Contagion

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For many longer term participants in Asian markets, the current global investment climate evokes memories of the Asian crisis of the late 1990’s. This time around, it was first the US sub-prime problems and now, a couple of years later, the Euro PIIGS (Portugal, Italy, Ireland, Greece and Spain) crisis. The two are connected. Asian market players see much of this as a repeat performance of the pan Asian financial crisis that kicked off on 2nd July 1997 with the devaluation of the Thai Baht. In that crisis “contagion” became a well ingrained part of investment thinking. It would be wise to take some lessons from that experience as a possible guide to the current more globally powerful risks emanating now from Europe.

Europe’s debt crisis is bringing an end to the post Sub Prime euphoria that saw most asset markets rally strongly since March of 2009 on the back of waves of liquidity injected into the global economic system by governments and central banks in what has been the grandest globally coordinated economic intervention the world has ever seen. This process has effectively done little more than transfer private debt from corporate and household pockets and park it in the pockets of governments. For that read the taxpayer! It is hardly any wonder that great swathes of middle class American and European households are up in arms. Most families and companies are generally cautious beings who have worked hard, saved their money, invested where they can, may own their own homes and generally lead conservative financial lives. Suddenly they are now forced to pay for the profligacy of those who have proven much less prudent in their financial dealings, taking on debt they will struggle to repay, in housing, credit cards, consumer goods, holidays. The providers of capital, banks, funds and governments, have encouraged this behaviour and now the entire population has to pay the bills. We should be surprised that popular discontent is not more voluble than it is.

Regional Stock Market Performance; Europe (STOXX Europe 600 INDEX), US (S&P 500), Non Japan Asia (MSCI Asia Pacific ex Japan Index) from 2008-May 2010.


There have been probably as many words, articles, TV programs and pundit prognostications on the Euro crisis as there were on the US sub-prime crisis.

Far be it from me to add to the reams of chatter on Europe’s problems. Taking a purely selfish view on the whole debacle, I am most interested in trying to understand the likely and possible impacts for the economies and markets of Asia, our back garden. We are guided in this to some extent by our experiences in the Asian financial crisis, the post sub-prime environment, as well as previous major downturns in Asia itself and the west.

The “C” word – Contagion – is back on centre stage in financial markets. Its first major appearance in the financial world in my experience was during the Asian financial crisis, where it was used, after the event, to describe the many pronged impacts that emanated from the original catalyst for the crisis. It is fair to say that no one really saw even half of the extent of the fallout of that crisis. And perhaps it is probably fair to say that no one really knows half of the potential fallout from the current European problems, which are tied at the hip with US financial crisis in my view.

Asian Real Estate Stock Indices Performance circa May 2010. Includes Bombay SE Realty Index, FTSE ST Real Estate, FTSE ST Real Estate Investment Trusts, Hang Seng Property Index, HS REIT INDEX, NZSX Property Group Index, S&P/ASX 200 Property Trusts, Shanghai SE Property Subindex, Taiwan SE Construction Index, Tokyo SE TOPIX Real Estate Stock Price Index, Topix REIT Market Index. Close Prices at 08 Jan 2010.

Learning from the Asian Contagion

The lessons of the Asian financial crisis may give some guidance as to what might be expected this time in Asian markets. As they say, history does not always repeat itself but it rhymes. The Asian financial crisis had its roots in many of the same economic ills that led to the problems in the US and Europe, but not a simple re-run of the Asian movie.

As regional strategist for Morgan Stanley at the time, with the great Barton Biggs as my boss and guide, I had grown increasingly nervous about directions in Asian economies in 1996 and into 1997, particularly South East Asia, and Thailand in particular. Asian countries were running growing current account deficits, managing rigged currencies, experiencing rising inflation, huge inflows of capital, both equity and debt, with soaring corporate debt (much denominated in lower interest rates currencies such as US$, Yen, Swiss Franc), huge property construction booms with mammoth oversupply in prospect, property bubbles. Tim Condon, our very prescient economist covering S.E Asia had been getting more and more negative about the sustainability of all of this. As a hard asset specialist, to me the massive property construction boom spelled disaster, with supply outstripping demand by multiples in these countries, but again, particularly Thailand. I had visited several Thai banks to be told that bank lending to real estate was no more than about 12% or so of total lending. Nonsense was my unspoken reaction. Just as recently in Dubai, China, anywhere, property of this scale is never built with all-equity, but with substantial lashings of debt. My conclusion was that the bank lending was going to companies that were labeled as “industrial”, and the loans classified as such. A similar pattern is going on in China right now with state owned enterprises.

In January 1997, Tim finally came out with his view that the only way out of this growing spiral of economic nonsense was for Thailand to let the currency go, delink its unofficial peg to the US$. And here is where the contagion issue starts to kick in.

Tim was spot on. Thailand did let the currency go a few months later in early July of 1997. While we had thought loosely in the intervening months about what a devaluation in Thailand might mean for the region generally, our thinking was a bit casual, not as disciplined and rigorous as it might have been.

Yes, we thought that any devaluation might be in the order of 10% or so – in the event the Baht went from around Bt23 to US$1, to around Bt50 to US$1. We were well wrong on even the first round effects. On second round effects, we hypothesized that other SE Asian currencies would also come under pressure if the Thai Baht devalued. Particular targets were Indonesia, Malaysia, Philippines. No one foresaw the extent of the devaluation in these countries either – Indonesia, which had been managing an annual devaluation of the Rupiah of about 3% – 5% per annum, suddenly saw its currency plunge from around Rp2300 to US$1 to Rp11000 and more. This meant that Indonesians were having to pay 4 times more local currency to buy US$ priced goods and services, and more critically, companies/banks were having to find 4 times as many Rupiah to pay back the huge foreign borrowings that they had racked up. Instant bankruptcy.

As analysts we correctly identified some of the broad likely contagion effects of a Thai Baht devaluation – currency pressures elsewhere, debt repayment problems, likely economic slowdown in most parts of SE Asia, more expensive imports for both consumption and business, asset price corrections, particularly real estate.


Our mistake in the late 1990’s was to underestimate the breadth, depth and duration of first order contagion effects in Asia, let alone the multitude of second and third order effects.



But we, along with everyone else, did not see anything like the breadth and depth of the fallout.

First was the extent of the currency devaluations – these were way greater than anyone expected, and that set the tone for the outcomes in other parts of the economy and financial systems of the region.

Second we erred on predicting the geographic extent of the contagion. Our initial thoughts were that this was largely a SE Asian problem. Wrong – very wrong. The contagion immediately spread to Korea, Taiwan, China, Hong Kong, where currencies came under pressure, asset bubbles burst, corporate bankruptcies soared, and debt burdens of companies and households created major problems for commercial and central banks. Some collapsed, and others teetered on the brink. Japan was already mired in its own troubles anyway, but collapsing economies in Asia did not bode well for corporate Japan, where hundreds of companies had recently spent fortunes setting up factories in SE Asia, Thailand and Malaysia in particular but also Indonesia and the Philippines.

Third, we were probably somewhat too optimistic on the timeframe of an eventual recovery. While governments and central banks rode quite quickly to the rescue, the bottoming process took a long time coming and the climb out of the hole was painful and long. Hong Kong, which was far from the centre of the storm, saw property prices plunge by around 60% over a 6 year period, and endured years of outright deflation. The pegged currency to the US$ meant that Hong Kong had to tough it out – it could not simply devalue its way out of the problem.

Fourth, the analyst/investor community largely underestimated the impacts on a range of economic variables, including asset price falls, unemployment, deflation, earnings downside, risks to banks, exports, domestic consumption.

Asia’s path out of this was a long, slow grind of deleveraging and repair of personal and corporate balance sheets that has only in recent years come back to “normal”. The fact that Asia was busy repairing its collective balance sheets perhaps prevented the region for falling prey to the problems that were brewing in western economies!

Note the words – a long slow grind. Many observers in the west, until recently at least, seem to believe that the world has all but returned to “normal” following huge government and central bank intervention around the world. The rally in most asset classes since March of 2009 has seemingly convinced many investors that the world has put the financial crisis behind it, and apart from some tidying up on the regulatory front, the world is back on a path of sustainable economic and financial recovery.

What about the long hard grind of deleveraging!

Having witnessed and lived through this process in Asia post 1997, I remain skeptical of the commonly held view that the world economy and financial markets are firmly set on a path of recovery following the worst, most pernicious financial crisis the world has seen since the 1930’s. We have seen the global contagion effects of the US sub-prime disaster, and now need to be thinking about the contagion effects of the European debt problems. Experience in Asia has perhaps taught us to think the unthinkable, that contagion impacts can be deeper and broader than we might have at first thought, that there may be all sorts of second and third order effects that come from out of left field, totally unforeseen.

Lets postulate some possible outcomes, and then try to identify some impacts for Asian markets and economies.

  • Europe (or most of it) experiences a deep recession. Asia’s experience suggests longer rather than shorter.
  • Recovery of PIIGS economies will be long and painful, partly due to much of these countries’ debt being external debt. This entails huge leakage of interest payments to foreigners (rather than to local investors) and big losses of tax revenues on interest payments. Again similar parallels with Asia in the 1990’s.
  • Credit ratings of nations and companies decline making the cost of borrowing and investment more expensive – more difficult to grow the way out of recession. Asia’s fate also in late 1990’s.
  • Likelihood of debt restructuring (a la Argentina/Latin America), perhaps even a European sovereign default – who knows what that would bring forth? The European Central Bank has claimed that default on public debt is “out of the question” – that is what we all thought about Russia in 1998, remember! Asia’s debt restructuring was largely corporate not sovereign – a long hard haul whatever the underlying cause.
  • Small businesses in particular may find even small amounts of debt difficult to obtain, driving them to failure, similar to US in 2008, and similar to Asia late 1990’s. Big impacts on jobs, domestic consumption, defaults on consumer loans, credit cards.
  • Bank failures? Not yet a big threat in Europe, but could be. A number of Asia’s banks went into government bailout mode in the Asian crisis. Nationalisation of some European banks – that has happened in the UK already, happened in Japan and parts of Asia. Certainly not out of the question in Europe.
  • Emergence of another inter-bank liquidity crisis. Bond markets for Greece Spain and Portugal are virtually dysfunctional now – could this spread, both to other sovereign debt instruments but also to the private financial sector?
  • Regulatory missteps born out of panic or frustration – Germany’s unilateral ban on naked short selling smacks of this. Such events can produce all sorts of unintended consequences. Some may prove positive for markets such as Singapore and Hong Kong.
  • Longer term, questions over the very sustainability of the Euro as a single European currency. A split between the “Southern comfort” countries and the discipline of northern orthodoxy? A two tier currency perhaps – remember China had two currencies at one stage in the 1980’s, as has South Africa more recently. What would be the impacts of such a development – I shudder to think.
  • A surge of social unrest across Europe as economies tumble and jobs are lost, wealth destroyed, social benefits and pensions cut. There seems to be little alternative but to cut social benefits and government spending in many European nations.
  • Political turmoil, governments brought down by popular uprisings, giving rise to drives for fundamental changes in the governing landscape and political institutions. A wholesale swing of the political pendulum and a rise of more radical left wing body politic.

The list could go on and on.

The first order contagion effects for Asia of the European sovereign debt crisis are not too difficult to identify, but second and third order effects are much more difficult to set out.

Global Increase in Risk Aversion is Underway.

First, the crisis is producing a new round of risk aversion in financial markets around the world, Asia included. The waves of monetary and fiscal stimulus that surged around the world in 2009 hugely increased investor appetite for risk, producing big surges in prices for just about most major asset classes – equities, corporate debt, commodities, wine, art…… Risk aversion is now coming back, and Asian markets are feeling the effects of this also as equity markets have largely reversed the 2009 uptrend.

Asia as Preferred Investment Destination Given High Growth to Take a Hit.

Second, a prevalent investor view over the past year suggests that Asia will continue to be the fastest growing region in the world. It has the ability, as a group of nations with huge savings, to pump up domestic demand to compensate for any downward trend in exports, the traditional drivers of Asian economies. To a significant extent this has proven so. In fact Asian central banks and governments may have over-reacted in the stimulus stakes creating risks of asset bubbles, particularly in real estate. Asian markets have been substantial capital magnets over the past year on the back of this perception. That attraction is likely to reverse in the short term as investor risk appetite globally shrinks and investors retreat to core safe have assets such as US/UK/German government bonds. Asian stock markets are generally likely to face some downward pressure near term as investor risk aversion rises. At this stage it appears unlikely that the lows of early 2009 will be tested, but it is not difficult to envisage scenarios that could lead to such an outcome.

Asian Exports to Europe equals those to the US – Will Come Under Threat.

Third, recession in Europe and long period of slow recovery has significant impacts for the core of Asia’s economic prospects also. Over the past decade Europe’s share of China’s exports for example have risen to equal that of the US/Canada at around 20% (see Figure 3). With both US and European economies on the ropes, Asian exports and underlying economic growth must be adversely affected. Yes, domestic demand can be pumped up to fill the gap at lest partially, but the ability to take up all the slack, and over a sustained period of time must be questionable. Expect to see further downgrades of medium term economic growth in Asia in the coming months. Shares of Asian Exporters are likely to continue to be under pressure near term.

Europe DOES Matter for Asian Economies: China Export sto Major Destinations (% of Total) from 1980 to 2009.

Asian Earnings Downgrades will Replace Recent Trend of Upgrades.

This will likely translate into earnings downgrades for large swathes of companies in the region. This will reverse the trend of earnings upgrades that has been in place over the past 12 months.

Expect Reversal of Recent Tighter Policy Settings in Asia.

In recent months policy settings in Asia have moved more towards a tightening bias as the effects of large stimulus packages have resulted in risks of asset bubbles and inflationary pressures. If we are right about the contagion effects of the European crisis, and prospects for economic growth soften materially, with asset prices stabilizing or falling, we could see a reversal of recent policy directions, back to a more accommodative posture. Continue to focus on domestic demand and consumer demand themes in Asian emerging markets.

China Will Put on Hold Any Moves to Let Currency Rise.

In the current climate the China Rmb revaluation trade will probably dissipate. The prospects of China resuming its path of gradual revaluation of its currency are much reduced. This alone could reduce inflows of investment to China (and other Asian countries), and impact asset prices in these markets, something the authorities are keen to see in some sectors anyway, particularly the real estate sector. It may also have the effect of dampening inflationary pressures at the margin, and thereby lessening pressures for interest rate increases in the region. A low interest rate environment is probably going to persist for some time in the region, despite recent suggestions of the reverse.

Infrastructure Spending to Increase.

Asian countries are likely to continue to boost infrastructure spending to shore up domestic demand and boost job creation to partly compensate for lower export prospects.
Construction and materials companies will continue to be beneficiaries.
Increasing trade protectionism may well be an outcome of weaker economic growth and export trends.

Financial Sector Regulatory Reform Plays Positively to Singapore and Hong Kong.

Regulatory change in the financial systems of Europe and the US is likely to result in the relocation of some areas of financial services to the more open-minded Asian markets such as Singapore and Hong Kong. This is already happening and it may be perceived as small in the total context of the European and US financial markets, but small numbers of businesses and people relocating to these markets has a big impact on local economies. Singapore in particular is doing an excellent job of actively courting financial services business to its shores. Hong Kong’s authorities are well behind Singapore in this regard. Again another fillip to Asian economies. High end housing and office markets are likely to be supported by these trends, particularly as supply is constrained and interest rates are likely to remain low.

While Asia is well positioned to ride out the worst contagion effects of the current European sovereign debt crisis, there are bound to be many knock on effects that may negatively impact Asian markets and economies. Our own experience with contagion effects in the past decade warns us that such impacts may take on greater proportions than we at first think and may take us in very different directions from what we expect. Past experience also suggests certain opportunities may arise from these events and also places to hide from the worst effects of the inevitable contagion.


HOWEVER—Asia observers carry an air of complacency about fallout from European debt and economic problems that may well prove to be misplaced.


Long Term Returns in Asian Real Estate Stocks – a Very Mixed Bag.

Many investors are surprised to learn that the listed Asian real estate sector has traditionally been the second most volatile industry sector in the world, second only to the Asian tech sector. The surprise is largely due, I believe to the fact that in markets like the US, the real estate sector is dominated by Real Estate Investment Trusts (REITs). These are vehicles that basically own real estate assets and are required to pay out pretty much all profits as dividends to shareholders. As such they have bond like characteristics. They sit somewhere between equities and bonds in the investment spectrum and as such have traditionally been a rather stable investment vehicle.

In Asia the real estate sector is very different and is made up of three main types of vehicle – property developers who have a build and sell business model make up around 60% or more of the universe of property stocks. Property investment companies that primarily own real estate for the long term make up about 25% of the sector universe. REITs are a relatively recent phenomenon for Asia and make up less than 15% of the listed real estate universe.

The preponderance of property developers in the sector I believe largely accounts for the greater inherent volatility in the sector.

A cursory glance at property price charts for key countries in the region also give indications of the volatility of the listed sector. It is commonplace in Asian markets to see property prices fall 30% or more in a downturn. For example, Hong Kong has seen six downturns in its property markets in the past 30 years, with two of these running to down 60% – 70%. By contrast, the US has never ever witnessed a national downturn in real estate prices, until just recently. There have been downturns in limited sub markets, cities or regions, but never an across-the-board fall in property prices.

Structure of the Listed Asian Real Estate Sector. Growth Style (60-65% of Sector Market Cap): Build & sell business model, Cyclical/volatile earnings, high asset turnover, Highe RoE; Primarily Residential Focus. Value Style (25-30% of Sector Market Cap): Buy/build to hold business model, cyclical but less volatile earnings, low asset turnover, Lower RoE; Primarily Commercial Focus, office and retail, with some industrial or hotels. Yield Style REITs (10-12% Sector Market Cap): Hold Assets long term, distribute all/most net income, Tax transparency; activities proscribed by regulation, stable lower growth earnings; Most property asset classes, less residential.


The Asian listed property sector is right at the top of the global volatility league tables. The underlying property asset prices have been more volatile than most other real estate markets. Moreover the listed space is dominated by property developers whose build and sell model is inherently more volatile than the “build and hold” property investment model.



The obvious question to ask given the volatility of property stocks is whether the sector produces higher returns for the higher volatility. The charts and tables here plot the long term performance of the listed property sector for a number of countries around the region.

The return characteristics are widely different across the region. For example, over a 35 year period (see Figure 5), property stocks in Hong Kong have given investors a compound annual return of 17.73% (simple average of 26.98%) against about 11.51%for the overall market.


An investor who parked $10,000 into the Hong Kong listed real estate sector in January 1974 would be looking at a portfolio worth around $3.03 million at the end of 2009. A reminder of the power of compounding! A similar investment in the overall market would have produced a portfolio of around $453,000.



China property stocks have produced stellar returns at almost 39% compound annual return, but the history of this listed sector is quite short. By contrast, property sector performance in smaller markets of Malaysia and Thailand has been relatively poor.

Long Term Returns of Asia Listed Property Sector vs Overall Market (by Simple Average, Compound Annual Return, Volatility, Worst Drawdown, Average Downside Volatility, Reliability of Gain/% of profitable years). Australia from 1982-2009 (Australia Real Estate Total Return Index vs Australia ASX All Ordinaries Index), China from 2000-2009 (China Property Index (H-Shares) vs Hang Seng China Enterprises Index (H-Shares)), Hong Kong from 1973-2009 (Hong Kong Real Estate Total Return Index vs Hong Kong Hang Seng Index), Japan from 1973-2009 (Japan Real Estate Total Return Index vs Japan Nikkei 225 Index), Malaysia from 1982-2009 (Malaysia Kuala Lumpur Property Index vs Malaysia FTSE BURSA MALAYSIA KLCI IDX), Singapore from 1985-2009 (Singapore Real Esate Total Return Index vs Singapore Straits Time Index), Thailand from 1982-2009 (Thailand Thai Property Developers Index vs Thailand SET Index).

Comparing Simple Averages, Compound Annual Growth Rates (CAGR), Volatility, Worst Drawdown, Average Downside Volatility and Reliability of Gain for the following markets: Hong Kong Real Estate Total Return Index vs Hong Kong Hang Seng Index. Australia Real Estate Total Return Index vs Australia ASX All Ordinaries Index. China Property Index (H=Shares) vs Hang Seng China Enterprises Index (H-Shares). Singapore Real Estate Total Return Index vs Singapore Straits Time Index. Japan Real Estate Total Return Index vs Japan Nikkei 225 Index. Malaysia Kuala Lumpur Property Index vs Malaysia FTSE BURSA MALAYSIA KLCI IDX. Thailand Thai Property Dev Index vs Thailand Thailand SET Index.


In most cases the listed real estate sector has considerably outperformed the overall market, but property sector volatility is also substantially higher. Higher returns have been accompanied by higher risk.



The Australian property sector stands out amongst its regional peers. Returns have been substantially higher than the overall market, as elsewhere, but volatility has been very similar to the overall market. Also noteworthy is the relatively small number of down years for the sector in Australia, and the fact that down drafts have generally been quite modest in size compared to other parts of the region. I suspect the fact that the Australian property sector is dominated by REITS rather than the property developers that dominate elsewhere largely accounts for the different performance characteristics. Dividends account for a very significant part of total returns, much more so than any other listed propriety sector in the region.

Hong Kong Real Estate Stock Returns CAGR=18%, Simple Average=30% (1989-2009). Property stocks vs Residential Prices.Japan Real Estate Stock Returns CAGR=4%, Simple Average=9% (1983-2009). Property Stocks vs Office Prices

 
Property is a cyclical industry as we all know. An active investor in the listed property sector who correctly calls the property cycles stands to gain very substantially from the buy and hold strategy, which has done very well anyway in some markets. For example, take our mythical Hong Kong property sector investor. Let’s assume he makes some correct calls on the direction of the listed sector, and manages to avoid being fully invested during the down years through holding say 15% cash (or some hedging strategy). His return would be substantially enhanced with his portfolio value theoretically jumping from $3.03m to $8.43m.

An investment of $10,000 in the listed real estate sector in Hong Kong in 1974 would be worth around $8.43m with some partly successful active management or hedging.


As a classic cyclical industry, calling the property cycles more or less correctly over the long term can dramatically enhance returns in the sector. For example, our Hong Kong investor, even if he had called the sector even partly right, avoiding just some of the downside in stock performance by holding 15% cash, could have turned his $10,000 investment in 1974 from $3.03 million to $8.43 million.



Australian Real Estate Stock Returns CAGR=13%, Simple Average=16% (1974-2009). Property Stocks vs Office Prices
Singapore Real Estate Stock Returns CAGR=8%, Simple Average=17% (1983-2009). Property Stocks vs Residential Prices

While the sector has produced stellar long term returns in a number of markets in the region the downdrafts in the sector can be brutal with the worst annual drawdowns typically deeper than for the overall market.

Thailand’s property sector has produced the most dismal annual return – down a jaw-dropping 98% in US$ terms. Thailand’s largest property company in the mid 1990’s enjoyed a market capitalisation of around US$3.5 billion at its peak. By early 1998 this had fallen to less than US$70 million! Another company I tracked at the time, Property Perfect, saw its market capitalization fall from around US$600 million to around US$2 million. A somewhat less than Perfect result!
However, the real estate sector in the major markets has had a good record of producing positive annual returns – 70% to 78% of the time the sector has produced positive returns in Australia, China and Hong Kong, and only slightly less in the case of Singapore.

Thailand Real Estate Stock Returns CAGR=1%, Simple Average=36% (1989-2009). Property Stocks vs Residential Prices.
Malaysia Real Estate Stock Returns CAGR=-1%, Simple Average=9% (1983-2009). Property Stock Returns.

In Figure 12 we get a little more granular by looking at monthly returns over the long term for the sector.

This analysis shows a clear differentiation between Australia’s listed property sector and the others. Monthly returns are much more concentrated in this market than others. About 63% of months in Australia have produced returns from – 2.5% to +5%. For other markets this figure is more like 35%. There is a much higher probability of big monthly returns or big monthly losses in other markets in the region, again reflecting the greater volatility of property stocks in Asia.

The probability of the property sector being down for 3 straight months or more in a row is quite low for all the major markets in the region.

Property Stock Index Performance Distribution (Monthly): Hong Kong, Japan, Australia, Singapore.

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