In mid-April we warned that a range of tactical indicators were flashing red (see “taking a pause for the cause”). As a result, we have had a relatively low net exposure to equities of 30%. At the time, most sell-side measures, our own risk indicators and investor sentiment surveys were near “euphoric” levels . The S&P500 or the global risk proxy was trading 15% above its 200 day moving average (with 97% of individual stocks also above the 200 day). Volumes had been falling as the S&P500 made new highs. Many of the leadership stocks have declined following the March quarter reporting season, despite achieving near record earnings relative to expectations. The big picture point was that the extremely bullish news was probably discounted in the price or already reflected in valuation. Following the “end of the initial recovery phase” a correction or consolidation is common before a further advance in the economic and market cycle.
In an Asian context, there has been a 12% correction in MSCI Asia ex Japan since mid-February. The ‘end of the initial recovery phase’ pull backs in 2004 and 2010 were almost twice as large. Therefore, the recent correction is not usual. It is an obvious point, but markets don’t move in a straight line. However, what is different in the current episode has been the rotation within the market. According to UBS, many stocks are up 39% since mid-February and 29% have rallied by more than 5%, while the overall market is down by 12%. Clearly there has been a significant rotation into cyclicals and “value” sectors. MSCI Asia Value has outperformed MSCI Asia Growth by 14% since the overall market peak. Although a lot more could be warranted based on the rise in Treasury yields (chart 1).
The value/growth rotation has benefitted our core (growth at a reasonable yield) equity basket which has a banks and materials bias. While it is tempting to blame rising yields (discount rates) or inflation expectations, the correction is probably more a reflection of excessive near term optimism, elevated retail participation and euphoric valuation in mid-February. To be fair, the elevated price earnings ratio was a reflection of depressed earnings that are now recovering rapidly after the crisis. On the positive side, the recent correction and the recovery in earnings has brought valuation back toward more normalised levels (chart 2). Moreover, the strategic case for equities is still compelling. Policy remains exceptionally loose (monetary conditions and fiscal policy, liquidity remains super-abundant, the equity risk premium remains relatively high (almost 5% in Asia) and equities tend to outperform until the output gap closes. Equities also offer pricing power or a hedge for inflation up to a point. Although clearly rising input cost pressure is a risk to profit margins.
Taiwan’s recent performance also embodies these trends. Foreign investors have been net sellers of Taiwanese equities since the market lows last year. In contrast, domestic retail margin loan balances are close to the 2018 high (prior to this week). Similar to other markets where retail investors have become a significant marginal influence on price, valuations in Taiwan have pushed to euphoric levels. According to UBS, implied return on equity in Taiwan is 18% next year or 2% higher than the previous peak in 2007. There are some very strong structural trends that support Taiwanese equities, including 5G and semiconductors. Historically, these sectors were highly cyclical. While we are always wary extrapolating cyclical assets to make secular arguments, there is clearly secular growth in these sectors and a genuine supply shortage in the near term. End of the Consolidation Phase
The good news is that the correction this week has also reduced some of the excessive optimism, leverage and overbought condition (chart 3). It is also why we have diversified our Asian technology exposure into Korea and China where valuations are arguably more attractive. Overall, Asian technology also trades at a material non-trivial discount to US technology on an EV/Sales basis and the exposure has more upside leverage to the global cyclical expansion.
In conclusion, the 12% correction in Asian equities since the peak in February has unwound excessive optimism in price, valuation, earnings, policy expectations and the overbought condition in equities. A consolidation or correction is also typical after the end of the initial recovery phase. The positive strategic case for equities remains in place; 1) policy is still exceptionally loose (monetary conditions and fiscal policy); 2) excess liquidity remains super abundant; 3) equities have some pricing power to offset inflation (up to a point); and 4) the equity risk premium remains abnormally high – Asian equities offer considerably more upside relative to sovereign bonds. We plan to use the recent correction to scale up our equity exposure over the coming days.