Recently when I was feeling a bit blue from these tough markets (thanks to the crisis in Europe, a faltering US recovery, and slowing China + India), flipping through some of the usual reading material, I came across this Bloomberg Businessweek cover page.
Have to say a wave of calm washed over me as I realised that we are not alone in feeling the pain. We even tried performing a couple of these “head bang” relief exercises before realising that it is just not very productive. I guess I was just trying to treat the symptoms (pain relief) rather than the cause.
Well, surely it is not the end of the world. The bright side is that with every crisis comes opportunity. No matter how painful the current condition is, hiding is hardly a good strategy. On this subject, maybe it is a good time to quote Sun Tzu “Those who excel at defense bury themselves away below the lowest depths of Earth. Those who excel at offense move from above the greatest heights of Heaven. Thus they are able to preserve themselves and attain complete victory.”
In my attempt not to bury myself below the lowest depth of earth and to stay calm, I would like to make a guess on where we are in the cycle and what are the challenges and the opportunities lying ahead of us.
Where are we in the cycle?
In the immediate post Lehman days in 2008, we at CLSA Jakarta quoted general symptoms of a market bottom from our favorite CLSA book, Marc Faber’s Tomorrow’s Gold.
According to Faber, there are seven phases in the life cycle of emerging markets.
Phase Zero – After a Crash
Phase One – The Spark
Phase Two – The Recovery Cycle
Phase Three – The Boom
Phase Four – Down cycle doubts
Phase Five – Realisation
Phase Six – Capitulation and the bottom
From the names of the phases alone, it is easy to imagine what happen in those phases, the valuation of the stocks, and the attitude of stock investors in general.
Events in Indonesia in those post Lehman days suggested that we were in Phase Five – Realisation. Some familiar events include: credit became tight, bond spreads widened considerably, economic conditions deteriorated, consumption slowed down noticeably, stocks entered a prolonged and severe downtrend as investors began to exit. And of course, stockbrokers laid off staff or closed down……..ummmm (Anecdotes on ground from Oct 2008 – attached)
The call turned out to be a very good one. Soon enough Phase Six, capitulation and the bottom set in. Many stocks have gone up 5, 10 even 15 times in the following years.
Four years on, the atmosphere can’t be more different.
Recently, the CLSA Jakarta office compiled tales of excess on the ground. I wrote about some of these excesses in the GlobeAsia March 2012 edition. Since then we have been collecting more signs of excesses. There is evidence of excess on the ground, starting from the capital markets, skyrocketing property prices, martial-art gurus turning to property consultants, super-expensive education fees to celebrities and nightlife.
Perhaps it is time to re-visit Marc Faber’s masterpiece work that we think should be read by any investors who invest in emerging market.
Reading through the symptoms of the six phases, it looks more like we are currently in Phase Three: The Boom.
Some of the symptoms of Phase Three from Tomorrow’s Gold:
– The business capital resembles a “boom town”, nightclubs packed with speculators and brokers who made their money in the stock or property market. During the day, there is heavy traffic congestion.
– Frequently a new airport is inaugurated and second one is in the planning stages.
– Industrial zones are planned and developed.
– Famous stock market speculators become folk heroes.
– The stock and real estate markets become a topic of discussion everywhere.
– Buzzwords such as New Era proliferate.
– Housewives become active in the stock market and many people give up their daytime jobs in order to concentrate on “playing” the market.
– Successful businessmen begin to invest actively overseas or diversify in other business sectors.
– Foreign money flows reach a very high level. Record number of foreign brokers who open offices during this phase.
Coincidentally or shall we say sadly, almost every one of those symptoms could be observed in our current daily lives, usually meaning we could be at the end of phase three or beginning of the down cycle .
Luckily, Faber did point out that very often the entire down cycle from 4-6 could be condensed meaning it occurs very quickly. That was certainly the case for 2008/2009. With the Federal Reserve and ECB (European Central Bank) committed to defying economics 101 (the boom and bust cycle), you can be sure that any sign of recession in their economies will be responded by printing an unprecedented amount of money. Perhaps so much so that we can go through phase 4-6 at warp speed without any pain and back to phase 2.
In physics, Einstein would call that a wormhole, a hypothetical topological feature of spacetime that would be, fundamentally, a “shortcut” through spacetime.
In “modern” economics, the Fed would call that QE. ECB would name that LTRO. The Chinese? Well …. they will probably just call it business as usual and we are not manipulating the Yuan.
Well, the gigantic bowl theory by Faber (also from same book) draws a parallel of where water flows (money) in with the tap controlled by the world’s central bankers. However, the bowl is uneven and will tilt to where investors exert pressure when fundamentals are in their favour. With more water, asset classes in that area will expand at a much faster rate.
Indonesia and ASEAN are the places where fundamentals are on our side. The correction could be short-lived as central banks globally have lower and lower tolerance for pain. And it will present a good buying opportunity, as long as we can address a number of challenges discussed below.
One key concern is that Indonesia has shifted recently into a current account deficit in the last two quarters, leaving its exchange rate exposed at times of heightened global risk aversion. In addition, Indonesia recorded a trade deficit for the first time in almost two years, as exports slumped throughout the month. Exports declined by 3.5% YoY (year-on-year) to $16 billion in April — the first since September 2009 — while imports surged by 11.65% YoY to $16.6 billion, resulting in a $641 million deficit. We expect this to continue given the negative outlook for exports while demand for imports will be sustained by continuing investment growth and robust demand.
The investment renaissance has been one of the key drivers of the Indonesian success story recently. Foreign direct investments (FDI) will be relied upon to support the balance of payments.
With FDI more than 150% of CA deficits, Indonesia is in a better shape compared to India, for example.
The 64 million dollar question
Recent government initiatives in the coal and banking space has led to a perceived “policy risk”, which potentially threatens the FDI cycle & balance of payments surplus.
As such, the big question is: will the strong FDI trend continue?
We think the best way to answer the question is to look at the reason for the strong FDI in the first place. In our view it is partially due to the under-investment that occurred in the post crisis decade.
Indonesia has gone through the Asian crisis 97/98 pains and embraced supply-side reforms. But the reforms post 97/98 era were super painful. For a decade or so, no one wanted to invest. The Political and business environment were extremely adverse. It does not matter how competitive the rupiah was. Credit collapsed and many corporations went broke.
In consequence, it took Indonesia six years to regain the contraction to real GDP that occurred in 1998. It was only in 2003 that GDP first exceeded its immediate pre-crisis level. This is the slowest recovery of the five countries that suffered big currency depreciation.
A large portion of the investment cycle strength today is owed to the under-investment that occurred in the period following super traumatic era of 97-98.
To conclude, we believe that the FDI cycle is a structural theme that will last longer as long as government regulations are consistent and continue to be pro business. That would be one indicator that we should watch closely as stock market investors.