East Looks Best        July  2001 - Issue 11

Unless a frequent traveller, it can be confusing to work out time zones and the exact time difference with one's own home base. In respect of a UK home base, an easier way to remember whether to add or subtract time zones is the short statement "East is least, West is best" meaning that we were behind the East in hours but ahead of the West.

When considering the investment prospects of the two halves of the world the aforementioned title may be more pertinent.

We have commented, ad nauseam, about the dangers facing the West, led by the fall out within the US by a multi year credit expansion of bubble proportions, which has led to massive over-capacity in many goods and services, particularly those with a technology label. Contrary to the now maligned 'New Paradigm' where the economic cycle has been tamed, the financial bubble pushed American households to extreme and unsustainable consumption creating precarious global imbalances, leaving both the US economy and financial system extremely vulnerable. Surprisingly, US consumption has continued, even in the face of increasing job lay-offs coincident with the now daily profit warnings by both new and old economy corporations.

Most financial guru's are still trotting out the same mantra, in that the US economy will recover in the second half of this year as the lagged effects of 6 in number interest rate cuts kick in. Whilst we doubt it, we hope that they are correct, as the prospects of a continued downturn are awful. Either way, we see little justification for chancing the Western equity market, particularly the US. As at the end of May 2001, the biggest and best 500 companies in the United States, known as the S&P 500, had a market capitalisation weighted P/E ratio of 39. This figure surpasses most prior bull market peaks, not bear market troughs or anywhere near the long run mean average of 14X for the S&P.

The tech laden Nasdaq 100 index looks even worse. Even after a 60%+ fall since the March 2000 peak, it trades on a P/E of 70X earnings, hardly cheap. The ripples from the US slowdown have now hit Euro Land, where again new and old economy stocks are hurting. Whilst the ratings accorded to Euro Land look more attractive than the US, cheap they are not.

Let us now travel East, an area not without its own problems. Japan still appears to be suffering from 'debt deflation dynamics' with the banking system in a terrible state. Banks are seeing new non-performing loans rise faster than the old ones are being written off. After a decade of economic stagnation since their very own bubble era, Japan's Nikkei 225 index is back below the 12000 levels, some 70% lower than its 1989 peak. Asia has also been frustrating for investors as it has tried to adjust after the devastating currency and asset value falls witnessed in 1997. Just as the area has stumbled back onto its knees, the tech bubble burst hurt their manufacturing base, particularly in Taiwan and Korea. Singapore is officially in recession and in Japan, economic conditions have deteriorated once more almost certainly placing it back in recession. So what gives us hope that East is Best?

Whilst recognising that in a global economy, all areas of the world will be affected by America's downturn, there are glimmers of hope, for the East. Japan, under new broom Koizumi at last appears to recognise that growth must increase, even if it is at the expense of a depreciating currency and inflationary policies. Whilst recognising the dangers in the shorter term of a weaker Yen pressuring Asian exports, we are not so sure that it will trigger a new round of competitive currency devaluations á la 1997. A weaker Yen will, in time, be beneficial to Asia as increased Japanese growth benefit this area as their part of the supply chain. 
  
Emerging Asian economies are no longer pegging their currencies to the $US dollar, an acute catalyst to the 1997 problems. With the exception of Hong Kong, all of the pegs have been abandoned, making these countries less susceptible to speculative attack from overseas portfolio flows.

Against the mighty $US these tigers are now very competitive in respect of currency, labour rates and productivity. Asia's share of global trade has grown substantially over the past decade. Currency account deficits have been eliminated, the opposite of America's position and of course they are still enjoying growth rates of double the West. All of this is without a mention of China, an economy growing at 7% PA.

In conclusion, in the short term we may yet see a crisis in Japan to speed along the reforms and devaluation hinted at by the politicians and of course, Asia would not be immune from it. Further out though, we see the pendulum swinging from West to East in respect of investment opportunity.

Charlie Aitken            25/7/01