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What And Where To Invest In The Dragon Year?
Malaysia Perspective | 10 February 2012

By Yeoh Mei Kei

2011 has been an extremely turbulent ride for investors as global markets endured a volatile year. 1H 2011 started with severe turbulence such as natural disasters in Australia (floods and a hurricane), followed by Japan’s earthquake which resulted in a tsunami and nuclear crisis, while mass uprisings were witnessed in Middle East and North Africa (MENA).

In 2H-2011, the European debt crisis decided to reignite itself as the crisis spread from Greece to more crucial countries such as Spain, Italy, and even France. Across the Atlantic, the downgrade of the US sovereign rating in August by Standard & Poor by a notch, together with the resurface of the fear of double-dip recession, have increased investors’ risk aversion. Equity markets started to bleed, while US treasuries have been the best performing bond sector as a result of investors’ flight to safety.

Although most of the worries and problems came from the developed markets, the heightened risk aversion has caused investors to sell-off riskier equity markets, i.e. emerging markets. Represented by the MSCI Emerging Markets Index, emerging markets plunged 17.6% (in RM terms) for the year of 2011 with BRIC (Brazil, Russia, India and China) as well as Greater China region (China, Hong Kong and Taiwan) being the laggards of the year. This compared with the 3.5% and -11.0% returns in US and Europe respectively.

As we enter into 2012, we discuss our key investment themes and identify the areas of opportunities as well as key potential risks that we expect investors could encounter in this Dragon year.

Investment Themes and Outlook for Dragon Year

2011 has been characterised by weak investors’ sentiment and risk aversion. A recent Merrill Lynch poll of fund managers in November 2011 indicates that around 5% of the respondents were underweight equities. With current extremely low yields in safe assets like US treasuries (not even enough to compensate investors for interest rate and potential inflationary risk) investors are expected to look for higher returns assets as the record low yield level in the developed sovereign debt also represents extremely poor long-term returns for investors. In 2012, we expect to see investors’ sentiment set to improve. Poor investors’ sentiment is likely to reverse as economic growth and corporate earnings growth could persist and remain on track in 2012 even after we factored in the potential mild recession in the Europe and a tiny growth in US. The decent growth in both economic and corporate earnings will leave investors with fewer concerns over the potential upside of the equity markets.

On the economic front, we expect Europe to have a mild recession, with its GDP likely to contract by 0.6%, mainly due to the implementation of austerity plan and cost-cutting measures. Economies like Spain and Italy are solvent, but are finding it difficult to access liquidity. While long term austerity will be required to reduce heavy debt burdens for troubled Europe countries, it is the near-term liquidity constraints which have the potential to shock financial markets. While we are clearly unable to predict how the crisis will play out, we believe that there are sufficient options (IMF funding, increasing the scope of the ECB as a “buyer of last resort” etc.) available which can buy troubled Europe sufficient time for cost-cutting measures to be effective. The US economy is still expected to expand, but growth rate is to be relatively tepid at 2.1% in 2012. With two major economies slowdown, this will undoubtedly weigh on overall economic growth. In an environment where growth is scarce, investors is likely to take the cue from multinational corporations which are increasing investments in faster-growing emerging markets.

In 2011, inflation in emerging economies has been driven by sizable gains in oil, food and property prices. From the relatively elevated levels of 2011, commodity price gains are not likely to rise by a similar magnitude (especially considering the slower economic growth anticipated), which should allow for more benign inflation in the emerging markets. More targeted policy responses in the housing market in countries like China, Singapore and Hong Kong may help to moderate property price gains, easing headline inflation further.

Furthermore,  as economic growth concerns take precedence over inflationary concerns, we expect most Central Banks to embark on a more accommodative monetary policy stance, as opposed to further tightening measures seen in 2010 and early 2011. Central bankers in Australia, Brazil and Indonesia have already cut rates in 2011, while others like South Korea and Malaysia have recently left rates on hold. With the fears rife over a potential hard-landing in China, we now believe that a reversal in monetary policy is imminent and could help to subdue growth concern. The People’s Bank of China (PBOC) recently cut the Reserve Requirement Ratio by 50 basis points in November 2011 (the first cut over the last three years) signals that the PBOC could further ease its monetary policy in 2012. As such, we expect China’s policy reversal could be a key market catalyst in sparking the equity market rally.

Implications For Investors

Investors’ confidence is clearly lacking now, as most of the equity valuations are at the level not seen since the 2008 global financial crisis (refer to Chart 1). In contrast, historically-low yields remain a feature of global bond market. With a three year investment horizon starting from 2012, we believe that equities with current low valuations will be more attractive as compared with bonds. As such, we maintain our “overweight” recommendation on equities.

On a regional basis, emerging markets are likely to find renewed favour with global investors after a disappointing 2011, and with growth opportunities scarce, we may see faster-growth emerging market equities commanding a sizable valuation premium against developed market equities going forward (refer to Chart 1). As such, our most favourable region for 2012 is emerging markets, undoubtedly. While Europe has been a constant source of worry for most investors, and given that the situation remains fluid, we anticipate significant volatility in European equity market. Thus, Europe is voted as the least favourable region based on our analysis.

Chart 1:

On single country basis, we favour China as after strong gains in 2009, China equities delivered poor returns in both 2010 and 2011, despite its economy maintaining a rather blistering pace of growth. Based on our estimates, China equities are valued at just 8.4X 2011 earnings (representing multi-year low valuations), and valuations declined to a paltry 7.1X 2013 estimated earnings (as of 13 January 2012). With extremely supportive valuations coupled with a shift towards more accommodative monetary policy, we think China equities are poised to deliver extremely strong returns from their current levels. On the other hand, Indonesian equities are least favoured, following three consecutive strong years. With its relatively shielded economy, Indonesia appears to have found favour with investors in recent years. Nevertheless, valuations for Indonesian equities are fair at best following three strong years of performance, and the market is less attractive compared against other markets as well as taking into consideration the high domestic government bond yields.

While we recommend an “overweight” equities position, investors should not forgo the bond investment as it helps to stabilise and diversify investors’ portfolio. Even though the bond market has generally fared well in 2011, riskier segments like high yield bonds have been negatively impacted by heightened risk aversion. The Asian high yield space now offers some of the highest yields within bond segments, while spreads in the US high yield space have also risen. Yields on emerging market debt remain high relative to developed sovereign debt, and investors may benefit from a potential convergence in yields between developed and developing market debt.

Lastly, with the above discussed outlook and implications, we wish one and all a profitable investment year with less stress in the Dragon 2012!

Yeoh Mei Kei is a Research Analyst at

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