Falcon Private Bank gives its calls on Southeast Asian markets, highlighting the countries it finds most appealing at current valuations.

The following commentary on the state of the Asian economy and markets is from David Prinkerton, chief investment officer, Falcon Private Bank. The views expressed here are those of the firm and the author. They are not necessarily endorsed by the editors of this news service but they are pleased to share them with readers.

Global markets have given investors little reason to increase Asian equity exposure in the first months of 2016, with a litany of risk factors at play: weak global manufacturing conditions, a collapse in oil and commodity prices, China stumbling on capital outflows and policy missteps, and Japan cutting to negative interest rates just as the Fed tightens its own policy at last. 

Moments like this – when fear rules – can provide outsized returns for those with the stomach for volatility. But deciding where to put your money when everything looks unsafe requires both a strategic approach to these risk factors, alongside a deeper understanding of each country beyond its index.

Take Southeast Asia, long a favoured growth story for global investors. Valuations commanded by ASEAN equities have slumped of late, pulled down by a growing distrust of emerging market assets and a fear of anything overly-leveraged to China. 

We do not believe across the board pressure on Southeast Asian stocks is warranted, nor that it accurately reflects underlying economic conditions. But how can one separate good bets from bad when putting money to work in the region?

First, we strongly believe equity investors allocating to these markets must consider the potential for further currency depreciation. We have found forex volatility to be one of the most important performance determinants for non-local investors; and in turn, foreign investor flows are often the most significant driver of local equity performance. In other words, while most regional currencies have depreciated sharply over the last year, markets where the depreciation cycle looks to be at an end have a higher potential of delivering significant equity upside.

Case in point would be Indonesia - where the rupiah has already depreciated significantly. We see the cycle as near an end, which could be the basis for later significant inflows coming from international investors seeking to participate in the country’s higher growth sectors. Thailand and Malaysia are both good examples as well, with significant FX depreciation over the last year. Complicating the investment thesis for equities in these two markets though are higher correlations with China.

Second, beyond the individual country currency issue - we must also consider the impact of the currencies from Asia’s two dominant economies: China and Japan. The renminbi and the yen are very important with China and Japan as major trading partners for many of these economies. 

If you take a Southeast Asian equity index with a heavy weighting towards exports, then yen or renminbi currency depreciation on a relative basis becomes a critical issue for the uplift or downside risk of these markets. 

Over the last few years, the yen has depreciated significantly as a result of massive local Japanese quantitative easing. While this current spate of risk-off sentiment globally has driven bids back into the safe-haven yen, the bank of Japan has countered this with an aggressive shift into an experimental policymaking phase with negative interest rates.

Likewise, China has been struggling to enact effective policy tools to manage the renminbi, with the country trying both one-off and gradual depreciation events as it tries to blunt the impact of a rising US dollar on its own economy. Policy misfires with the offshore renminbi and mixed market messaging from competing authorities have only deepened concerns that more volatility may follow.

The third issue to consider when allocating to ASEAN markets is to make sure that one cultivates a deeper understanding of local equity market index composition. It is a common mistake to infer or read a headline about an economy and then assume that this is perfectly translated to the influence on the local equity market.

Far from a broadly representative list of stocks - Southeast Asian benchmark indices from Singapore to the Philippines remain highly concentrated in financial and telecommunication stocks. Index composition can also favour national champions in a particular category, with Thailand’s benchmark for example directing top allocation to an energy company. 

This means that a call on market indices is in effect a call on these specific industries, rather than a call on the broader economies. For this reason, a combination of macro risk overlay and bottom-up stock evaluation is important when crafting Southeast Asia allocation decisions in the current market cycle. 

As it stands, we generally find Indonesian and Thai stocks as the most attractive markets within the ASEAN equity space. Malaysia is moving towards more inviting valuations, though investors must be sector specific when allocating to the country. We suggest investors skip Singapore at the moment due to its defensive nature and relatively rich valuations.

We would also hold off on investing in the Philippines for now, given the country’s relative outperformance versus regional peers in the last few years, and the impact this has had on both valuations and the chance for future outperformance.