Churchouse Letter
January 2010          by Peter Churchouse

Moving Economic Mountains

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A Favourite Lunch of the Year

Every year for the past 8 or 9 years, I have been invited to a December 31st lunch in Hong Kong hosted by the head of one of Hong Kong’s oldest and biggest companies. This lunch has been running since the early 1970’s. It is a very congenial affair with about 12-14 participants, a few from the senior ranks of the company, the balance from the local financial community, including usually someone from the stock exchange or government. Apart from enjoying a splendid lunch, accompanied by a glass or two of even more splendid Burgundy and Bordeaux, the lunch has a slightly serious dimension to it. Discussion focuses on the outlook for markets over the coming year, locally, globally, various asset classes, property, and of course, given our location, outlook for China economics, markets and policy.

Each year there is a little guessing game in which all participants are asked to write down their predictions for five data points for the coming year: the gold price at next year end, the value of the RMB (China’s currency) at next year end, the high for Hong Kong’s Hang Seng Index during the coming year, the low for the year, and the yearend close for the index.

A prize is awarded at the end of the year to each forecast that is closest to the actual figure for the year. The grand prize is awarded for the guess closest to the year end close of the Hang Seng Index. This prize is a delightfully tacky little sculpture (from the 1970’s) sitting on plinth on which is engraved the names of the winners over the years. It reads as a bit of a who’s who of Hong Kong finance over the years.

Asian Real Estate Stock Indices Performance circa January 2010 - J-REITs/New Zealand the Underperformers in 2009. 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.

MSCI AC Asia ex Japan Index from Q1 2007-Q1 2010

It is a fun little exercise that, despite its geniality, participants take quite seriously. I have to confess to having won the grand prize on two occasions over the years that I have been invited (including the painful 2008 year), with one participant featuring three times on the winner’s plinth. This is not to boast, because we all know that such guesses are all about being less wrong than being actually right!

For this year’s lunch, just completed, the consensus amongst the participants at the beginning of 2009 seemed generally much more bearish than my own. Although I was a few hundred points adrift from the closest to the yearend index, (the grand prize), I did win the closest guess for the low point for the year (HSI of 11,344.58) and the high point for the year (HSI of 22,943.98). I did expect a volatile year with a wide spread in Index performance.

This lunch for me is a little prompt to sit down and rationally (hopefully!) work through the issues that I think will drive these particular markets over the course of the coming year. Invariably, in the case of Hong Kong, a very open market, it forces one to think of the drivers of the global economy, China, the US interest rate environment (HK interest rates are virtually linked to US rates due to the pegged currency), the dollar, property markets, government and central bank polices to name just a few.

At the risk of deeply embarrassing myself a year from now I will share with you my guesses/predictions made at this year’s lunch for 2010. Also I will outline very briefly my rationale for these guesses. (I use the word “guess” deliberately, because that is what they are.)

Gold Price: US$1,325 for end 2010.

Rationale: The US$ has been oversold in 2009. A temporary rally in the US$ is likely to continue into the coming few months, supported by the realization that the potential US economic recovery is ahead of those in other main currency blocs – Euro zone, Japan, UK. However the spectre of rising inflation, massive public sector debt service needs, will come back to haunt the currency markets and gold will make a return as the asset of safe haven status, setting new highs before the end of 2010.

China’s Currency: 6.58RMB= US$ by end 2010.

This is much more about second guessing China’s policy makers than making a hard core economic call on a currency. I think we can safely say that as long as US and Euro politicos continue to beat China with a verbal stick to revalue its currency, the more we can be sure they will do at least nothing and perhaps even the opposite. However, if China’s economy continues to boil along at a 9%+ rate of knots (and western politicians shut up!), I think there is every chance that China will engineer a slight up-tick of its currency from RMB6.83 level that it has been at for more than a year to around RMB6.58 to the US$. This might also marginally help offset a rise in inflation that I expect in China this year. It will be a slight upward revaluation as China’s leadership is exhibiting signs of paranoia about risks of a slowing economy and will do nothing that jeopardizes its growth aspirations.

Chinese Yuan vs US Dollar (CNY=) Q1 2006-Q1 2010. Fear of Economic Slowdown has Halted China's Managed Currency Appreciation.

Hang Seng Index from Jan 2009-2010 - Now at Mid-Cycle Valuations

Hang Seng Index: 2010 High – 28,231; 2010 Low – 17,858; 2010 Close 26,150.

The Hang Seng Index closed 2009, just before our lunch, at 21,872.5…… The market is currently trading at about 17.5 times forecast 2010 earnings and at a price/book ratio around 1.5 times. The PE is a bit higher than longer term averages of, and the P/BV is about average. So while the market has enjoyed a grand rally in 2009, it is basically in Goldilocks territory right now, roughly at mid – cycle valuations. There is some reason to think that earnings estimates for 2010 could be on the low side, particularly if China’s economy continues to roll along backed by easy money policies (that the government has indicated it will continue). Analysts are typically slow to revise numbers down in the economic slowdown and slow to revise up as the economy recovers. And by end of 2010, the market should be pricing in 2011 earnings expectations. Clearly my guesses assume that the global economy does not totally fall off the rails, and that a repeat performance of a Lehman type event does not occur. Fears of global government debt concerns, potential inflation and interest rate risk will likely make their mark at some point, knocking the market back by around 18% – 20% from its December 2009 level. But I expect that the “China factor”, solid earnings growth prospects and decent corporate balance sheets of Hang Seng companies will win out, with the market trading up to close the year around 26,000, still well short of its record high and well below bubble valuations seen in previous cycles.

Let’s see how badly I might embarrass myself!

Moving Economic Mountains

What a difference a year makes!

If nothing else the events of the past year have demonstrated that coordinated multi-national actions have the power to move economic mountains. What might mankind achieve if such commonality of purpose were applied to other aspects of human affairs – environmental degradation, climate change, regional conflict to name but a few.
It seems world leadership was able to rally round to fend off an economic meltdown, but cannot do so to collectively solve far more important problems that actually threaten our very existence on this planet.

In late 2008 we were staring over the precipice at financial and economic disaster. The cavalry in the form of the world’s major central banks and governments were riding rapidly to the rescue bearing arms in the form of truck-loads loads of cash to be dispensed willy nilly to anyone that needed it, but most particularly the worlds largest financial institutions. That the world was sliding into recession was not in doubt, but what was in doubt was whether the cavalry would be able to forestall a 1930’s style recession – images of depression soup lines, dust bowl countryside and despairing populations all over America suddenly loomed large.

A year on, things look very different. Injections of literally trillions of dollars of monetary and fiscal stimulus has pulled the world back from the brink of disaster. A year ago we were in considerable doubt as to how much stimulus would be delivered by probably the most coordinated international effort ever, and whether it would have the desired effect. Optimism was in very short supply indeed.

Twelve months on, it almost hard to imagine the difference in mood in capital markets. The cavalry charge worked!

Virtually every major asset class has enjoyed rallies from solid to truly spectacular – developed and emerging market equities, corporate bonds, commodities, real estate in some markets, gold. Many capital markets seem to be pricing that the recession is over, and the world is pretty much back to normal. Is it really?

As we approach the Year of the Tiger, we inevitably have the urge to take stock, clear the decks and try to unravel thoughts of what might be to come in the up-coming year.

Today the thoughts that exercise our minds are very different from those that were up close and personal a year ago, so different as to be virtually unimaginable back then. Many of the concerns we see today are to do with the problem of excess liquidity, the exact opposite of what exercised investors’ minds a year or so ago.

There are about as many opinions out there as there are individuals who express them.

Here, I will try to summarise the key issues that seem to divide the world of economic thought in hopefully a simple but not simplistic way.

Massive liquidity injections saved the world from imminent disaster, at what price and what next?

The world has breathed a huge collective sigh of relief that the huge coordinated injections of liquidity orchestrated by central banks and governments has produced what seems like a much softer economic landing than what was likely without such actions. Growth numbers in a great many countries seem to have bottomed and appear as if recovery is either well and truly established or at least imminent.

But as with most massive interventions there have been a great many unintended or unforeseen, no more so than in this instance.

The Great 2009 Carry Trade.

Policy makers wanted to see the liquidity generated by massive injections directed to certain potential users: Consumers and home owners, small businesses caught in the inter banks lending drought of 2008, investment in new businesses, job creation. However very considerable amounts of this liquidity found its way into unintended culdesacs. Banks bailed out by TARP/TALF (and a variety of other acronyms) have taken cheap capital and sat on it. Rather than lend it to main-street, they have applied much of it to lifting bank reserves and repairing damaged balance sheets. Other recipients of cheap capital have been emerging market equities, corporate bonds, high yield currencies, and in Asia, real estate. Banks have used cheap capital to profit buying treasuries rather than lend to companies and households. There will likely be political ramifications of this.

So massive injections of liquidity have not only benefited the real economy to some extent, but have produced sharp rallies in a wide range of global assets. Borrow US$ cheaply and buy higher yielding assets anywhere you can, and, Oh, by the way, benefit from a weak US$ when time comes to pay back. Banks and fund managers have done very well in 2009 adopting such strategies. No one knows how much has been applied to carry trades of this kind, but record trading profits reported by certain investment banks and hedge funds suggest that this is far from inconsiderable. Is a reversal likely? Emerging markets and high yield currencies may be victims if these carry trades are unwound in a big hurry.

Left:MSCI Emerging Markets Index from 1988-2010. Right: J.P. Morgan Emerging Market Bond Index from Oct 1999-Jan 2010. Huge liquidity injections have boosted emerging market equities and bonds.

Sustainability of Economic Recovery. How Questionable?

The second half of 2009 saw the impacts of liquidity injections play through into real economic growth with the US leading the way amongst major developed countries. UK and Europe are lagging behind the US in this recovery. The big obvious question is the extent to which this economic recovery needs continued support from central banks to survive. Has the consumer the ability to pick up the baton of recovery? Will domestic investment pick up sufficient momentum to support the recovery that has started in recent months?

There is considerable doubt that the recovery is sustainable without continued very loose monetary and fiscal policies. Unemployment in the US at 10% (significantly higher in parts of Europe) suggests domestic consumption will remain weak. Consumers are saving more, deleveraging, adding to these concerns. Home prices are soft, and still large numbers of households are facing foreclosure in the US, and to a lesser extent in parts of Europe.

The output gap in most parts of the developed world is high, with capacity utilization at low levels. This suggests demand for new investment is likely to remain weak. Who wants to build new plant when existing facilities are operating at 80% of capacity?

Equity markets seem to be priced for sustainable global economic recovery, which in my view, is more doubtful than markets seem to be implying.

The Deepest Recession in the Developed World in Many Years but Coordinated, Expansive Monetary and Fiscal Intervention Has Engineered the Beginnings of a Sharp Recovery.

Left: US's GDP growth rate from 1980-Jan 2010. Right: Germany's GDP growth rate from 1991-Jan 2010.

Left: UK's GDP growth rate from 1981-Jan 2010. Right: France's GDP growth rate from 1981-Jan 2010.

Left: Italy's GDP growth rate from 1981-Jan 2010. Right: Japan's GDP growth rate from 1981-Jan 2010.

Money Supply = Inflation. What happens to Bond Markets?

Conventional economic theory suggests that large growth in money supply inevitably proves inflationary at some point in time, and central banks with a mandate to manage inflation will be forced to raise interest rates. There is little doubt that central bankers around the world are wary of this outcome. Hence the recent focus on “Exit Strategies” in financial media. When and how will policy makers see fit to back away from stimulus measures? What happens here is hugely important to bond markets as well as prospects for sustained recovery. Expectation of rising inflation should send bond markets into a tail-spin.

The bond bears hypothesize that inflationary pressures from huge monetary stimulus are as inevitable as night follows day – it just might be a longer day! This camp tends to look at the sharp rise in the monetary base as a harbinger of substantial rise in interest rates.

There are two distinct schools of thought on this.

The US monetary base is now close to 150% higher than in late 2008. Over the long term, proponents of this school of thought note that the difference between GDP growth and growth of the monetary base is very close to the inflation rate. Today inflation is minus 2% while money base has grown at more like 11% (if excess reserves are deducted from money base), so a gap of about 13% or so. Over the years this gap has averaged more like 4% or so – that means that money supply growth has been roughly 4% higher than GDP, with inflation averaging around 4%. The current difference is the highest discrepancy between the two variables ever recorded, and suggests a big surge in inflation is likely/inevitable.

Long Rate Spreads in US & UK Seem to Be Pricing Inflationary Expectations

Left: US 30-Yr Treasury and Fed Funds Rate spread from 1991-Jan 2010. Right: UK 30-Yr Govt Bond and 3-Mo LIBOR Spread from 2000-Jan 2010

Some support for this school of thought also comes from the sharp rise in asset prices in many markets around the world in recent months. Remember how the Fed, Bank of England and others ignored asset price inflation in the lead up to the current debacle!

The bond bulls on the other side of the fence postulate that governments and central banks have the tools to withdraw liquidity from the system in a way that will not only maintain inflationary pressures at low levels, but also keep short end interest rates low. Some in this camp also note that inflation is not just a product of the SUM of money base but the VELOCITY of money also. Velocity is lower than normal at present the bond bulls note, and therefore inflationary pressures are more muted. This school of thought notes the weakness of domestic consumption, weak investment, the output gap, high unemployment – all deflationary or at least disinflationary forces.

Some bond bulls also argue that the Fed and Treasury in the US have the ability to absorb excess money supply via a range of tools. In fact Fed Chairman Bernanke has just proposed a method for achieving just this.

This involves the Fed selling interest bearing deposits to banks which would thereby drain some of the excess liquidity that was pumped into banks during the crisis from the banking system. In this process banks would place reserves at the Fed rather than lend them out back into the broader economy. The Fed claims that such a policy could be executed independently of monetary policy decisions – Fed speak for saying this could be done without raising short term interest rates.

There are other ways that the Fed could absorb excess liquidity, for example selling bonds to a public that is now saving like dervishes. Making such purchases tax beneficial would add to the attractiveness of such a strategy for a public that is being taxed up the Yazoo.

From this part of the cycle it is hard to see serious inflation rising any time soon in the west (Asia may be a different story). However, even a whiff of inflationary pressures, perhaps coming from a rise in commodity prices, or a reversal of any one of the economic variables above could easily raise EXPECTATIONS of inflation, and that could be sufficient to send bonds into a quick retreat.

Being stuck in bond long positions could prove expensive later in 2010 if the Fed misjudges its ability to soak up excess liquidity and the economy does in fact show robust, sustainable growth, and rates make a leap up.

The Piper Needs to be Paid. Fiscal Deficits in Dangerous Territory.

Yes, trillions of dollars of stimulus have been applied to the rescue of the global economy, but someone has to pay for all this largesse. Countries of the western world, and indeed many emerging markets, are seeing substantial rises in national debt arising from their stimulus programs. The US budget deficit as a percentage of GDP is likely to be around 10% in 2010, and that for the UK is tipped to be close to 12%. There is growing muttering of governments defaulting on public sector debt. Problems in Greece are bringing this issue into focus. Sovereign default is highly unlikely in most instances. But having said this, that is what the markets believed in 2008 in the Russian example of the “too big to fail” doctrine!

Even if widespread government defaults are unlikely, there is risk of a good number of sovereign ratings downgrades. This brings with it the risk of rising bond yields, making governments less able to service debt, pushing rates higher in an ever more vicious cycle. Government responses typically will focus on raising taxes – we are seeing plenty of evidence of that right now – with all too obvious implications for investment, consumption and economic growth. Or governments will tolerate higher future inflation as a means of devaluing debt incurred today?

Long and short – Governments may ultimately end up paying more to entice investors to buy their debt, and will raise taxes to pay for it all, with negative implications for growth. You can bet your bottom dollar that governments will NOT reduce aggregate public sector spending.

Public Sector Deficits – Will Endure for Years & Become More Expensive to Finance

Left: Left: Euroland Deficit as of GDP from 1980-Jan 2010. Right: PIGS Deficit as of GDP from 1980-Jan 2010 (Portugal, Italy, Greece, Spain)

Left: Global Titans Deficits as of GDP from 1980-Jan 2010. Right: Asian Tigers Deficit as of GDP from 1980-Jan2010.

Currencies a Bigger than Normal Factor. Asian Assets Do Not Like a Strong $

The short US dollar trade became very crowded in 2009, with the result that the US$ probably became oversold. That position has reversed with a recent dollar rally, driven partly by perceptions (reality?) that US economic recovery is leading that of other advanced economies, and by some gentle warnings sounded by some sovereign authorities for whom US$ assets comprise a large part of reserves – China in particular. A weaker dollar has undoubtedly helped US exporters, and the current account deficit, and a stronger dollar runs the risk of some reversal of this support.

A stronger US$ could see some reversal of the US$ carry trade, with negative impacts for some emerging markets which have benefited from this scenario. Asian asset markets, over the years have traditionally done well under a weak US$, and underperformed during periods of US$ strength. Asian currencies have traditionally been formally or informally tied to the US$, so a strong dollar makes Asian exports more expensive to non-US$ buyers.

Short term, US$ will probably remain in the ascendancy, but longer term structural issues associated with budget deficits, deleveraging, bank problems, and the impacts of these for US government bonds still remain.

Asia’s relatively stronger economic growth prospects may dull the negative impacts on Asian asset prices that we normally see associated with a strong US$. Moreover, Asian governments have been less inclined to aggressively “peg” their currencies to the US$ since the Asian financial crisis of the late 1990’s – there is somewhat more flexibility in currency policies these days – China excepted.

I would not be surprised to see China quietly let the RMB gently rise again from its current level of around 6.83 to the US$ at some point during the coming year. It will not do this as long as the US and others push the idea down the throats of the Chinese leadership.

US Dollar Index and MSCI Pacific ex-Japan Index from 1987-Jan 2010. (Asian markets do not like a strong dollar.)

Gold – Investment of Choice for Structural Bears.

If you believe that deficits and/or inflation will bury bond markets, and lead to structural decline in the US$, gold and commodities will probably be your investment of choice. Gold has certainly outpaced most developed world stock markets in the past decade. Structural risks to major economies, bond and equity markets and major currencies looking ahead are probably greater today than at any point in the first half of this decade. A goodly allocation to gold should probably be at the core of any long term investment portfolio. A smattering of allocation to other commodities should also provide some insulation in times of stress – people still need to eat, and the population of the planet keeps growing. Environmental degradation, floods and droughts coupled with growing demand should underpin prices of basic foodstuffs on a medium term view.

Some sub-plots:

Housing markets: Not Over Yet.

At the risk of flogging a dead horse, we should be mindful that the housing debacle in the US and some other western markets is not over yet. While foreclosures have risen sharply and mortgages which have missed at least one payment are now around 10% of the total in the US, the foreclosure cycle is far from over. About 4.5% of total mortgage loans are in the foreclosure process. While there continues to be a huge supply of unsold homes, and unemployment hovers around the 9% – 10% level, it is hard to see the problems of the housing market going away quickly. Large write downs and write-offs will continue to dog the financial system.

While still grim, there are some rays of light in the housing markets. Sales volumes have probably hit rock bottom, and may accelerate a little from here. Developers now have lower inventories than for about 30 years, and word coming from some of the larger developers is that construction is picking up again. Good news for the economy no doubt, but pricing is unlikely to recover quickly, and high levels of foreclosures are going to continue for some time.

Commercial Real Estate: Real Fallout Just Beginning.

So far it has been largely about residential markets, now it is the turn of the commercial property markets. In key US cities commercial property values have fallen by anything from 30% to 50%, with rising vacancy rates and falling rentals. As we noted in our report of “Commercial Real Estate Debt; Next Shoe to Drop”, we can expect another very large round of bank failures in the US prompted by non-performing real estate loans. This time it is not the big national banks and institutions, but hundreds of smaller local and regional banks whose loan books are sometimes dominated by loans to commercial real estate. The coming year will see a sharp pick up in non-performing commercial property loans, and we expect that the eventual outright losses to be taken by the banks and other lenders to commercial real estate will be in the order of US$300-$400 billion, and it could be a lot higher.

Some 140 banks were absorbed, taken over, failed in 2009 – the body count will rise further in 2010, eventually topping the 900 mark.

Where Do We Stand in Asia: What Are Our Best Guesses?

While Asian asset markets are pricing in a sustainable “V” shaped recovery of the global economy, there are enough “nasties” out there to make this far from a foregone conclusion in my view.

The threat of a relapse is very real, but most asset markets are not really factoring this in -at least yet.

From the perspective of looking at our “Asia Hard Asset Universe”, we see the prospects unfolding as follows.

The real estate markets of many parts of Asia have rebounded very sharply in 2009, having “gone out in sympathy” with western markets in 2008. Structurally Asian property markets were in much better shape than many western markets going into the global crisis, with little of the debt and construction excesses that drove western markets over the cliff. There were some exceptions, China and India being the two more obvious ones.

Substantial fiscal and monetary injections both at the local level and globally as well as low interest rates have underpinned this rally. Now talk is more of property bubbles than deflation. While we can argue the toss about whether property markets are or are not in “bubble” territory, it is a rather moot point, because central banks and governments are acting as if markets already are in a bubble or acting to prevent one from occurring. In China, Hong Kong, Singapore, Korea and Taiwan policy makers have fired warnings shots across the bows of the property markets. These shots at one end of the spectrum have been pop-guns so far in the case of markets like Taiwan and Korea, but China is bringing out the artillery. China’s authorities have not just sounded warnings but have implemented a range of controlling measures aimed at curbing excesses in property markets both at the level of the developer community as well as the consumer/investor end of the chain.

While many Pooh-Pooh these measures by the Chinese authorities, I am loath to do so. If the policy makers see excesses in property markets leading to potential systemic risks to the banking system through big rises in non-performing loans (NPL’s), we should be under no illusion that they will keep introducing more and more monetary, fiscal and administrative measures until such measure have the desired effect. (see list of policy measures in Table 1 at the back of this report)

Hong Kong’s government and the Hong Kong Monetary Authority have also introduced measures from mid October aimed at curbing excessive lending and potentially “speculative” trading in the local property market. Singapore’s authorities have also reacted to the very sharp rebound in residential property prices seen in the 3rd/4th quarter of 2009.

The result of this policy intervention has been a slowdown in property sales volumes in the past couple of months in these markets. In Hong Kong average residential property prices fell back about 1% – 2% since mid October warnings from a rise of about 28% since February of 2009. Share prices of property companies have reacted predictably to the uncertainty of policy interventions, with flat (at best) to down performances in the past couple of months.

If the residential property markets were left to their own devices, without policy intervention, I suspect we could see prices in markets like Hong Kong, China, Singapore surge 30% or so. But it is NOT an unfettered environment. Policy makers, having recognized how property market excesses led to the financial crisis which plunged the world into recession, are not about to let that happen easily in Asia.

So if property prices surge in the near term, we can expect policies to be introduced to curb rising property prices. Prices will likely be capped at levels that are lower than might have been the case in the absence of intervention.

In this environment it is hard to be overly enthusiastic about the prospects for the mainstream developer stocks in these markets in the near term. Stock prices of major developers are reflecting the likelihood of further intervention in these core markets. As a result, I expect the shares of major developers to underperform in the near term in markets such as Hong Kong, China and Singapore, despite them enjoying robust sales and rising earnings in 2010, particularly in China where earnings growth of 20% – 40% is the norm for 2010.

Short term I would be underweight property stocks in an Asian portfolio given policy uncertainties surrounding markets where “bubble” is becoming part of the daily vocabulary.

Curiously enough, if property prices level out, or maintain a more modest upswing, then the risk of intervention will recede and shares will likely bounce back reflecting fundamental earnings prospects and asset backing.

CHINA: Within the regional property space, China property companies will deliver much superior growth than will be the case in any other major market in the region. In this environment I would bet on the larger property companies in China to outperform the sector in the short term. As they are backed by state owned enterprises they are likely to weather policy uncertainties better than purely privately owned companies. In addition it is noteworthy that government sets loan quotas typically in November/December for the coming year. Typically around 40% to 45% of the loans for the coming year are advanced in Q1 and the large state owned property companies are likely to be at the front of the queues for any lending that they may want. They also have very diverse portfolios across many cities in China, and it is likely that not all cities will feel the heavy hand of regulation equally. They are also enjoying strong sales and earnings growth this year, (20% – 40% is the norm) with pretty much most of 2010 earnings already locked in through pre-sales in 2009. China Overseas Land & Investment Ltd (0688.HK) and China Resources Land Ltd (1109.HK) and China Vanke Co Ltd (200002.SZ) are three such candidates that fit the bill here, and although are not the cheapest stocks in the sector, valuations are not now overly stretched given their growth and market positioning. These companies are likely to be the long term bell-weather companies of the property sector. In a market which has spawned more than 200 listed real estate companies in the past decade or so, with more than 30,000 property companies nationwide, picking the likely long term winners is a challenge, but these companies are looking increasingly like long term leaders in the space. I also like SOHO China Ltd (0410.HK) for its strong balance sheet (no debt), strong near term growth prospects, cheap valuation (around 7X 2010 earnings) and its focus not just on pure residential but also on commercial/office property for sale. This sector is less likely to be a target of policy interference.

HONG KONG: There is much talk of a residential property bubble developing in HK given the market’s sharp recovery since February 2009. Policy makers are responding with modest measures aimed at cooling the residential market, and have succeed in slowing transactions and prices down in the past 2 – 3 months. Economic, monetary and industry conditions are likely to produce further upside in property values and rentals in most sectors in 2010. Stocks have leveled off since policy noises started in October but have enjoyed a renewed uptick in the past month. The sector is trading at pretty much its long term valuation measures on a Price to net asset value basis, and a little higher than average Price Earnings ratio. Earnings growth is much more muted than in China, but positive nonetheless. Gearing (and hence financial risk) is by far the lowest in the region. Sun Hung Kai Properties Ltd (0016.HK), the largest listed property company in the world, should benefit from its exposure to both recovery in residential and commercial markets, its large agricultural landbank (which can be converted to development status) and its increasing forays into the China market. Good news is well signaled in the residential market, but commercial rentals are still bumping along a bottom. I believe we will begin to see some better news flow in commercial property in the coming months, and that may drive decent performance of property investors stocks and REITs. Hongkong Land Holdings Ltd (HKLD.SI), Champion Real Estate Investment Trust (2778.HK) and Prosperity Real Estate Investment Trust (0808.HK).

SINGAPORE: Market themes in Singapore are similar to Hong Kong. Residential prices have surged 20+% in the 4th quarter. The office market faces some supply issues, but rentals are forming a bottom. Again our balance is towards commercial real estate plays, and although share prices have rallied, yields on some Singapore commercial REITs are still attractive, but don’t expect much growth. Singapore REITs have recapitalized nicely in 2009. Names to consider are CapitaCommercial Trust (CACT.SI), CapitaMall Trust (CMLT.SI).

NZSX Property Group Index from Q4 2004-Q1 2010

LITTLE COUSIN—NEW ZEALAND: Australia’s little cousin has suffered a more painful economic tumble than its resource rich neighbour, but its large real estate trusts have actually fared better through lower gearing, less complicated structures and less bloated balance sheets and expectations. Although there has not been a major building boom, office vacancies have risen, rentals have fallen and capitaisation rates have risen, with the obvious factor on property prices. That has probably run its course, and if experience in other Asian, UK, and even US markets is anything to go by, stock markets may begin to impact in some fall in cap. rates (i.e. values rise), possible future rental growth , acquisitions, into share prices of listed property trusts such as AMP NZ Office Trust (APT.NZ), Kiwi Income Property Trust (KIP.NZ), and Goodman Property Trust (GMT.NZ). These trusts are also all paying gross dividend yields of around 8+% right now.

All in all property stocks in the region have generally enjoyed the 2009 liquidity induced rally, and given the high beta of the sector, have outperformed their respective indices. Valuations are now “fair” in relation to their history and given their prospects.

Broad based outperformance of the sector cannot be expected in the short term, and if you are in the camp that expects a sharp reversal of the US market, then the Asia property stock high beta will likely prove painful in such a sharp reversal.

Date Policy Summary
22 Oct 2009 China announces a series of policy changes:lower mortgage rates, reduced down payments, lower transaction taxes. The down payment for an initial purchase of housing with a floor space of more than 90 square meters for self use could not be less than 20 percent. Previously, the figure was 30 percent.
03 Nov 2009 China’s banking regulator plans to review debt levels at some real-estate developers on concern the companies’ borrowings are fueling excessive gains in property prices. The China Banking Regulatory Commission wants to reduce leverage at developers that bought land at inflated prices and at large state-owned companies that have entered the property market.
18 Nov 2009 Central bank adviser Fan Gang said that the nation needs to be on alert for stock, real estate and commodity bubbles as global capital flows into emerging economies
07 Dec 2009 Accelerate “urbanization” process, incorporate migrants into the coverage of urban social security, housing securities and other public service systems.
09 Dec 2009 The new tax policy requires anyone selling a secondhand apartment or house within five years of its purchase to pay a sales tax of 5.5 per cent, extending the taxable period.
14 Dec 2009 The government should “maintain the continuity and stability of its policies” and curb “the excessive growth in home prices in some cities,” Xinhua reported.
17 Dec 2009 China raised the down payment requirement for land purchases to at least 50 percent of the total price, the Shanghai Securities News reported, citing the Ministry of Finance.
21 Dec 2009 China may raise the down payment requirement for purchases of second homes to 50 percent in a bid to curb speculation in the property market, Beijing Business Today reported.
28 Dec 2009 Chinese Premier Wen Jiabao said the government will cool property prices, resist pressure for the Yuan to appreciate and keep inflation at “reasonable” levels. “Property prices have risen too quickly in some areas and we should use taxes and loan interest rates to stabilize” them. China will “absolutely not yield” to calls for currency gains, he said. The government will maintain a “moderately loose” monetary policy and a “proactive” fiscal stance, Wen said, adding that it would be a mistake to withdraw stimulus measures too quickly.
31 Dec 2009 In Shanghai, home buyers must prove they are first-time purchasers before benefiting from a reduced tax on transactions.
04 Jan 2010 China’s factories cranked up production in December on the back of bulging order books, but the strong demand also pushed prices higher and raises the specter of inflation.
06 Jan 2010 In the south, Shenzhen will carry out a three-month crackdown on property speculation, China Business News reported Jan. 6, without citing anyone. China will limit credit for some home purchases to reduce speculation and rein in surging prices, Housing Minister Jiang Weixin said. The nation will “further restrict credit for the purchase of second homes and curb speculative housing investments,” Jiang said in a statement on the ministry’s Web site today after an annual work meeting.
07 Jan 2010 China’s central bank surprises market by raising the auction yield of its three-month bills for the first time since mid-August. The significant step-up in liquidity tightening sends offshore non-deliverable interest rate swaps (NDIRS) sharply higher.
08 Jan 2010 The People’s Bank of China sold three-month bills at a higher interest rate for the first time in 19 weeks. The central bank has kept its benchmark one-year lending rate at a five-year low of 5.31 percent after five reductions in the last four months of 2008, and in the first 11 months of 2009 allowed a record 9.21 trillion yuan ($1.4 trillion) of new bank loans. The PBOC will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated on the Web site of China Finance, a central bank publication.
10 Jan 2010 Government agencies announces that it will increase monitoring of loan flows to prevent funds illegally entering the property market and so- called “hot money” from affecting China’s markets, the State Council said today in a statement posted on the government’s Web site. China’s cabinet reaffirmed a 40 percent down-payment ratio for second homes after speculation that the requirement would increase. The government will “guide reasonable housing consumption and curb speculative investments,” boost land supply and accelerate the construction of lower-priced, smaller homes, the statement said. The State Council said that different loan and tax policies for purchases of first and second homes, and for “regular” homes as opposed to bigger and more expensive ones, must be “strictly” implemented. The government will crack down on property developers hoarding land or delaying projects and probe local authorities’ circumventing related central-government policies, according to the statement.
12 Jan 2010 The People’s Bank of China raised the proportion of deposits that banks must set aside as reserves by 50 basis points starting Jan. 18. The People’s Bank of China (PBOC) also raises the yield on 20 billion yuan ($2.9 billion) in one-year bills after holding it steady in the previous 20 auctions, and drains a record 200 billion yuan from the financial system via 28-day bond repurchase agreements.
13 Jan 2010 China renews vow to curb runaway property price rises by increasing the supply of affordable housing and cracking down on speculation.
17 Jan 2010 China’s banking regulator asks banks to be cautious on their lending strategies this year, ensuring credit is used in the real economy and not for speculation. It also calls on banks to monitor the property sector and make “greater efforts” to control their loan risks.
18 Jan 2010 China’s central bank allows one-year bill yields to rise more than expected, signaling in open market operations that its quantitative tightening was still intact but also that it aims to shift fund drains to longer-term tenors to rein in lending and fight inflation.
19 Jan 2010 China reaffirms it will maintain “reasonable growth” in credit and money supply, and stick with proactive policies to boost domestic demand, but will also curb speculative property investment and take steps to deal with inflationary expectations, Premier Wen Jiabao says.
20 Jan 2010 Chinese banking authorities reportedly instruct some major banks to curb their lending over the rest of January after an early burst of credit.


Interest Rate Movements Do Not Always Produce Expected Results in Asian Real Estate Stocks

Fed Funds vs MSCI AC Asia Pacific ex Japan Index from 1984-January 2010

Black Line: Fed Funds
Red Line: MSCI AC Asia Pacific ex Japan Index

Fed Funds vs Hang Seng Property Index from 1987-January 2010

Red Line: Fed Funds
Black Line: Hang Seng Property Index

Fed Funds vs Singapore Property Index - REITs from 1999-January 2010

Black Line: Fed Funds
Red Line: FTSE ST Real Estate Investment Trusts

Fed Funds vs Singapore Property Index from 1999-January 2010

Red Line: Fed Funds
Black Link: FTSE ST Real Estate Index

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