China and India: Too much too fast

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Markaz Research

China and India: Too much too fast 21 - Oct - 2007

Markaz research recommends inclusion of GCC to contain Global risk The Emerging market Indices especially that of China and India have witnessed a bull run as never seen before. There have been structural factors which can be attributed to the same. However, Kuwait Financial Center S.A.K. (Markaz), in its recently published report “China & India: Too much too fast” has expressed that the run up is too fast and is a cause of concern. The report points out to inclusion of GCC markets in the portfolio to soothe the probable risk of a bubble bust. Figure: The Bubble Scale Areas of concern Increase in the benchmark indices at breakneck speed. The India’s benchmark index Sensex took 4 days to climb 1,000 points (from 18,000 to 19,000) while it took nearly 13 weeks to climb from 12,000 to 13,000. Worse, it took 175 weeks to move from 4,000 to 5,000! Similarly, China took only 36 days to cross the last 1,000 points (from 6,000 to 7,000) while it took nearly 2,000 days to move from 2,000 points to 3,000 points! This magnitude of increase at such short time duration was witnessed in other markets too, only to ensure that the resulting fall being faster. This is termed as a bubble burst, which was witnessed in the case of NASDAQ, Nikkei and also in the case of Saudi Arabia. The report points out to similarities by comparing the number of days the index took to move 1000 points, and, the results are quite revealing. Nikkei took only 70 days to lose 10,000 points while it took 556 days to move up. Closer home, the Tadawul index to descend from its historic peak of 20,000 points to 8,000 points took a mere 93 days, while the ascent from 8,000 to 20,000 took 309 days! All the markets, where the bubble burst witnessed a similar trend of a quick up move just before the fall. Record Valuation Levels Technically, a bubble is set to burst when it violates certain norms. A good place to verify would be valuations of the benchmark indices. The rampant flow of liquidity in the form of Foreign Institutional money into these economies has stretched valuation limits beyond its sustainable means. This phenomenon has been observed in other bubbles that bust. For e.g. at the peak of its bubble, Saudi Arabia’s P/E touched 40, only to settle down to 15 now. So was the case with NASDAQ, Nikkei, etc. An inspection of the Price to Earnings (PE) multiples across markets reveal that China at nearly 30x (MSCI Country Indices) is in the super-hot zone along with Morocco and Chile, while India with a PE of 24x has migrated to hot zone within a span of 3 months. Most of the emerging markets, including India and China trade far higher than their historical average. Based on past five years average, only one market (Peru) is trading below its historical PE average. Leading the unattractive pack are China, Argentina, Brazil, India and Indonesia. Liquidity: The Primary Driver of “Hot Money” In the emerging markets the chain of liquidity creation feeds into stock markets in the form of foreign investments. This is also called “hot money” as they reverse gear at the signal of slightest trouble. The Indian economy that has virtually seen no worthwhile foreign investment of any kind till 1992 has witnessed inflows of unimaginable scale during the last three years. India’s average annual foreign equity portfolio investment was $1.7 billion for a period of 26 years (1978-2004). Contrastingly, $11 billion of investment was invested into India in the year 2006 alone! Markaz research note believes that this is a situation of excesses flowing in all of a sudden, and, coupled with this an appreciating rupee is a recipe for a classic disaster waiting to happen. Table: Foreign Portfolio Investments ($ million) Average (1978-2004) 2005 2006 2007F China 1,571 20,346 42,861 25,000 India 1,710 12,489 11,500 17,000 South Africa 402 5,940 12,997 7,500 Brazil 1,512 5,620 6,801 7,400 Philippines 251 1,460 2,339 4,500 Turkey 114 5,669 1,939 3,600 Russia 511 -948 8,298 3,200 Thailand 718 5,644 5,580 3,000 Korea 2,955 -361 -6,000 2,500 Indonesia 617 -165 1,900 2,000 Source: Markaz Research, Institute of International Finance Inclusion of GCC as a soother & the reasons Markaz research argues that in the current scenario of over heated emerging markets, it is prudent to add GCC to reduce downside risks. Re-rating in crude oil prices & robust GDP growth For much of 90’s and early 2000, oil prices stayed course between bands of $10-30. However, this was pierced during 2004 where oil prices took on a path of continuous upward momentum primarily helped by Chinese and Indian demand for oil and supply fears due to geo-political situation in Iraq, Nigeria and Venezuela. Oil market pundits believe that the tight demand-supply situation is likely to prevail for foreseeable future giving credence to the theory of re-rating of oil prices to a new band of $60-80, with even higher expectations among many analysts. GCC countries benefited from the twin combination of increased oil production and increased oil prices with the results that economic growth turned robust while current account and fiscal balances reached unprecedented levels. Real GDP growth projections for Qatar and UAE are next only to China, while other GCC countries are not far behind. Increasing investment scenario GCC economies have announced investment projects worth a staggering $1.4 trillion which will form the bedrock of growth for the coming decade. Saudi Arabia, UAE and Kuwait account for the bulk. Investments are planned across various infrastructure oriented sectors like construction, power, water, etc. While the earlier oil boom triggered investment primarily in the oil sector, this time around the story is quite different. Surprisingly, construction sector accounts for 65% of investments planned as GCC economies are in dire need to upscale their infrastructure capabilities. GCC markets performance & Correlation GCC stock markets have exhibited superior risk-adjusted performance relative to other emerging markets during the past five and half years with Kuwait standing out distinctly. Kuwait infact leads the pack with the highest Sharpe ratio followed by Oman. The GCC index enjoys a higher Sharpe ratio than the emerging markets and developed markets. Coupled with this, GCC markets also enjoy lower correlation with emerging and developed markets both in the short-term (last twelve months) and long-term (from 2002 till September 2007). During the last 12 months, negative correlation increased for emerging market and S&P 500 compared to GCC providing a good de-risking opportunity to global investors. Valuation attractiveness of GCC markets Nearly a quarter of emerging market universe has already moved into the super hot zone of valuation, however, three-quarters of GCC universe trade within the normal/attractive zone. The P/E’s considered are that of MSCI indices which takes into account only stocks available for foreign buyers. Local indices indicate even paint a grimmer picture; especially for China whose P/E is touching 60! Contrast this with Saudi Arabia (Tadawul Index) whose P/E is now at 15. History suggests that share prices could continue to rise for a lot longer: both Japan’s Nikkei and US’s NASDAQ experienced p/e ratios of well above 100 at their peaks before they cooled off. However, our bubble scale clearly indicates that this may happen sooner than we think for emerging markets as this time the markets involved are from emerging markets whose macro and micro structures are yet to be tested. A pre-cursor of this was seen in late February 2007, when a 9% drop in Chinese share price triggered a brief global sell-off. It is instructive to reflect 10 years back on the Asian financial crisis, which China managed to keep away from due to its strong grip on the currency but more importantly from its weak global integration. Today, more than 35% of global growth accrues from China. This time around, if China sneezes, the world’s market will catch not just a cold but bird flu! ### About Markaz Kuwait Financial Centre S.A.K. 'Markaz', with total assets under management of over KD1.40 billion as of June 30, 2007, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was awarded a BBB+ corporate rating by Capital Intelligence Ltd.