Equity markets go up and they go down — it is part and parcel of economic cycles, though volatility is usually higher in the short term. While one would attempt to buy low and sell high, the reality is that few, if any, are successful on a consistent basis. More often than not, investors would chase a rally on the fear of missing out (FOMO), sell in a panic when stock prices unexpectedly fall and stay on the sidelines for too long and miss out on the subsequent recovery. The point is that short-term stock price movements are highly unpredictable, and this is why we say timing the market is rarely a worthwhile endeavour.
Stay in the market. Over the long term, equity markets generally go up as the domestic and global economy grows (see Chart 1). Obviously, however, the total returns for each market will vary in degrees, owing to differences in economic, political and institutional dynamics. Some equity markets will perform better than others. In other words, the absolute return on your portfolio is dependent on two main factors — the time in market (the compounding effect) and choice of investments, that is, which markets to invest in.
Staying in the market means that you will have to ride the ups and downs. All economies go through boom (usually accompanied by rising stock prices) and bust (falling stock prices) cycles. Typically, boom cycles are fuelled by private credit expansion, where an increased money flow into the economy will drive investments, jobs creation and consumption. In addition, a rising stock market generates a positive wealth effect that further boosts consumption, resulting in a positive feedback loop. But unsustainable credit expansion could lead to asset bubbles. Eventually, over-leveraged households and businesses and/or the bursting of asset bubbles would result in an economic slowdown and, in a worst-case scenario, recession and even stagflation.
How quickly each economy and equity market recovers from a downturn will depend on its underlying economic dynamism, the ability to adapt to new conditions quickly and effectively. To be sure, past performance does not guarantee future performance. Each cycle has different characteristics and challenges, and the economic structure and political environment, as well as leaders — and therefore, how they react — for each country also changes with time. Still, we think there is value in studying how each country navigated boom-and-bust cycles in the past, for clues on how its economy and equity market might perform in the future.
Table 1 shows the relative performances of select bellwether indices for the year to date, since 2020 and over the last 10, 20 and 30 years. US stocks have consistently outperformed almost all major markets in the world over the different time periods, which include intervals of economic expansions, downturns and recessions.
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This is why we have allocated 30% of Tong’s Absolute Returns Portfolio to US stocks. We believe the US economy and Corporate America are more resilient and can continue to grow faster than most of the developed world for the foreseeable future, underpinned by their own economic dynamism as well as the immense privileges gained by virtue of the US dollar hegemony and the US’ economic-political-military dominance in the world (which we have articulated in our last few articles).
On the other hand, the European market, as a whole, has not fared as well. We think its economy will continue to underperform that of the US. Therefore, we have chosen only one Europe-based stock, Airbus, which is in fact a global business.
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US and Japan: Different economic dynamics
Many of the past drivers of the US’ economic success remain in play. Its population is, by and large, well educated — the US understood the importance of, and invested in, education for the masses well before the rest of the world did. Its universities and research institutions are highly regarded, attracting hundreds of thousands of foreign students each year, and many of the best and brightest end up in its workforce. A well-educated and skilled workforce is closely associated with productivity gains and economic growth.
The US has well-established and inclusive, political, economic, social and judicial institutions, including a strong legal system that ensures the rule of law, protects individual and property rights, as well as a free press. This provides a system of checks and balances. The economy is founded on the principles of free market competition. Yes, there is inequality and, yes, this is a growing problem, and a cause of increasing polarisation and erosion of trust in public institutions. The rich have many advantages over the poor, but career advancement and success remain largely based on a system of meritocracy. In other words, the potential for upward social mobility is open to all, which also makes it a magnet for foreign talents. Case in point: Many of the largest US corporations are headed by foreign-born Americans or those of immigrant descent. The US has a comparatively open immigration policy, including various programmes to attract skilled workers with a clear path to citizenship, at least until recent years.
The business environment, too, is open and competitive. And most businesses can react quickly to change, including layoffs, given the country’s relatively weak labour protection laws. The weakest links will (are allowed to) fail during economic downturns and recessions, so there is greater efficiency in allocation of resources. Bankruptcy laws are relatively lenient (such as allowing businesses to retain control during restructuring), and the culture is more forgiving towards failure. There is limited government intervention, except when systemic risks are high. Such an environment allows for faster turnaround time from recessions and fosters entrepreneurship and greater risk-taking (supported by deep private and public capital markets), the key drivers for investments, innovation and productivity gains.
Case in point: The shale revolution — using the innovative technique of hydraulic fracturing and horizontal drilling — provided a cheap source of energy for domestic use and turned the US into a global leading producer (and exporter) of oil and natural gas. No doubt, it was a major factor underpinning the US’ economic recovery from the Global Financial Crisis (GFC) and subsequent growth, for instance, in terms of jobs and wealth creation as well as adding to economic diversity and resilience.
The last two major recessions in the US (excluding the Covid-19 pandemic) were preceded by easy access to credit and low interest rates that fuelled the dotcom bubble (1990s) and subprime mortgage crisis that led to the GFC (2000s) (see Chart 2).
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The stock market crashed, many internet start-ups with unsustainable business models failed and unemployment spiked after the dotcom bubble burst. But private credit recovered quickly and, critically, investments (as a percentage of GDP) remained steady. The US Federal Reserve cut interest rates, which went on to fuel the housing market bubble and subprime mortgage crisis that morphed into the GFC — and the US Great Recession from 2007 to 2009. Again, the stock market crashed. This time, it was households that were over-leveraged. It took years for households to repair their balance sheets, but the stock market recovered quickly to new highs. The point is that the US environment is conducive to fresh starts, with forgiving bankruptcy laws and free market competition driving entrepreneurship and innovation. For instance, many internet companies that survived the dotcom burst, notably Amazon.com, adapted and emerged much stronger.
And, yes, arguably, the US has the advantage of the Fed (the de facto central bank of the world) that acted as the “shock absorber” in each crisis — pumping in or removing liquidity, and dictating its interest rates (and those of the rest of the world), with its effect on global exchange rates, too.
Similarly, the period of easy credit (following financial sector deregulation) and lowering of interest rates drove private credit expansion and excessive speculative activities in Japan through the 1980s, pushing stock and real estate prices to unsustainable levels. That eventually culminated in the asset bubble burst at the turn of the decade. In Japan’s case, however, private credit did not recover for a very long time, with credit growth staying negative for most of the years since then (see Chart 3).
The dynamics of the Japanese and US economies are quite different in several key aspects. After the collapse in stock and real estate prices, many Japanese businesses were sustained by government support and infusion of cheap money, instead of shutting down and/or quickly restructured. The government’s response was slow and piecemeal, allowing the problem to fester. We think this was due in part to its culture and the social stigma of bankruptcy and failure.
The Japanese emphasis on, and importance of, long-term relationships between businesses, banks, employees and customers kept highly indebted businesses alive, turning them into zombie companies that weighed on the efficiency of the economy and investments for years to come. When you have to spend a huge chunk of earnings on interest expense, it leaves little for investments. Banks, saddled with bad debts, became risk-averse and lending contracted. The protracted economic downturn led to Japan’s lost decades. Demographics (ageing population) and the country’s restrictive immigration policy are contributory factors to Japan’s economic stagnation. Investments as a percentage of GDP declined as Japanese households and businesses chose instead to invest abroad (huge increase in FDI outflows) in search of better returns.
It took the Nikkei 225 index more than three decades to return to its pre-bubble burst high. On the other hand, the Standard & Poor’s 500 index has more than recouped all lost ground from both of its major crises far more quickly. If you invested US$100 ($136) in the US bellwether index in 1991 and rode through both the dotcom bubble and GFC, your investments would be worth nearly US$3,000 today (total returns including dividends). By comparison, investing the same amount in the Nikkei 225 index would net you little more than US$150 over the same period. “Same time in market, different market choice” can yield very different results.
We are not entirely convinced that Japan has sustainably escaped its crippling deflationary-growth stagnation cycle. The jump in inflation since the pandemic is cost-push, owing to supply chain disruptions and geopolitics-driven rises in energy costs, similar to what happened in the US and the rest of the world.
To be sure, there are promising signs of stronger wage growth, and corporate governance reforms are attracting renewed investor interest, lifting the equity market to fresh record highs. Japan is also benefiting from the diversification of supply chains out of China, including in the semiconductor sector. For instance, Taiwan Semiconductor Manufacturing Co (TSMC) recently commissioned a chip fabrication plant in the country and is planning for a second one.
Still, it remains to be seen whether prevailing policies can sustainably raise inflation expectations and, more importantly, boost consumption and economic growth when the population continues to shrink. While the weak yen is helping exports, it is also raising the cost of living. And the government must eventually address its massive debt burden, the cumulative result from years of running huge fiscal deficits, without stifling growth or causing financial instability.
Asean economies and equity markets post-AFC
As with the cases in the US and Japan, the Asian financial crisis (AFC) was preceded by a decade of rapid economic growth, underpinned by easy credit and a healthy dose of speculation as asset prices rose. Businesses, especially, relied too heavily on borrowings, including foreign currency loans and short-term capital inflows, to fund investments. The sudden reversal in capital flows forced the devaluation of the Thai baht in mid-1997, triggering a domino effect across the region.
In the aftermath, countries that turned to the International Monetary Fund (IMF) for assistance — namely, Thailand, South Korea and Indonesia — underwent business closures and restructurings (to varying degrees) that are more similar to what transpired in the US than in Japan.
For example, even though the South Korean government intervened heavily (to prevent systemic collapse), financial assistance came with strict restructuring and governance reform conditions. The government also opened the domestic market to foreign competition, forcing companies to innovate and raise productivity, and expand globally. South Korea’s foreign direct investment (FDI) outflows rose sharply in the ensuing years. The governments in Thailand and Indonesia provided comparatively less direct intervention, thus resulting in more business closures than in South Korea. But the IMF-mandated reforms placed all the countries on stronger footing on recovery — even though unemployment rose sharply in the immediate fallout, which did lead to economic hardship and social unrest. Importantly, investments as a percentage of GDP in all three countries recovered from post-AFC lows and have been relatively stable. And the stock markets in South Korea and Indonesia have far eclipsed their previous highs.
Malaysia, on the other hand, spurned IMF aid and instead turned more insular, imposing protectionist policies, capital controls and selective bailouts of highly indebted businesses. Capital controls severely damaged investor confidence. The stock market never recovered its former lustre and attractiveness to foreign investors. Trading volumes and retail participation have contracted sharply from those heydays. Malaysia’s share of Asean FDI also dropped the most (in percentage terms) among its peers post-AFC (see Chart 4). Domestic capital outflow jumped once all capital controls and the US dollar-ringgit peg were finally abandoned in 2005. As a result, investments as a percentage of GDP declined steeply, and the country relied increasingly on consumption to drive growth, which was unsustainable. Malaysia experienced “premature” deindustrialisation. (See Chart 5).
Decade of ultra-low interest rates have driven debts higher worldwide …
The ultra-low interest rates that prevailed globally since the GFC have stimulated credit expansion around the world (see Chart 6). For instance, Vietnam has been reporting strong private credit expansion in tandem with rising economic growth, which is driven by growing exports. Investments as a percentage of GDP are comparable to those of South Korea and Indonesia.
Excessive liquidity has also fuelled a rapid rise in housing and stock prices in many countries, some probably unsustainably so. In many Asian countries, home ownership is widely regarded as a necessary milestone for success in life. And the long housing boom is driving up household debt. For instance, in South Korea and China, mortgage accounts for more than half of total household debts. South Korea now has one of the highest household debt levels (as a percentage of GDP) in the world while China’s household debt has also risen steeply. While mortgages are relatively low risk, as long as the underlying real estate prices do not collapse, high indebtedness will dampen future consumption. This is one of the reasons that China’s domestic consumption growth is anaemic.
Thailand may have an even bigger problem. The country has the highest household debt level among Asean peers, two-thirds of which are considered non-productive (for travel, luxury items, consumer goods and such). Only about one-third of the borrowings are for housing. Its central bank has so far resisted pressure from the government to cut interest rates.
… Raising the risks of unsustainable asset bubbles and another financial crisis
High indebtedness raises the risks of unsustainable asset bubbles and another financial crisis as interest rates stay higher for longer and especially if economic growth slows.
We believe that Asean, as a whole, will continue to record stronger-than-global average economic growth for the foreseeable future. While we do not want to miss out on this growth, we also want to minimise the risks of exposure to any one country. As we said above, many Asean countries are showing signs of financial stress. History has shown that policy responses can vary greatly from country to country and the differences had long-term consequences, which go on to affect the subsequent performances of their economies and stock markets. Bear in mind also that the governments of today can react very differently from that of the past.
Given that Singapore is the de facto financial and business hub for the region, we opted to invest in two Singapore banks, DBS and OCBC, in our portfolio as the “safer” proxy for Asean growth.
Will China be more US- or Japan-like?
That brings us to the biggest uncertainty that is China, the world’s second-largest economy. There is no doubt that its economy is facing big challenges on multiple fronts. The economy is slowing and in transition at a time when geopolitical tension with the US is rising. Meanwhile, inflation has been in rapid decline post-pandemic and moving into deflationary territory, dragged by falling real estate market. FDI (as a percentage of GDP) has contracted sharply, dropping to the lowest levels in 30 years, as a result of geopolitics. And its high-tech ambitions are facing hurdles from US-led trade restrictions. The question is, can it rebound quickly like the US, or will it fall into a slow burn and stagnation like that of Japan?
China possesses some of the strengths that underpinned the US’ economic success, including an educated and skilled workforce, strong entrepreneurship and a competitive business environment that drives innovation and productivity. But it also shares some similarities with Japan, including an ageing population and cultural background such as a greater propensity to save — owing partly to the absence of social safety nets such as unemployment insurance — and higher aversion to bankruptcy. And unlike either countries, China has an authoritarian system of government. This can be a double-edged sword.
One problem with autocratic rule is that the top-down approach punishes dissent and contrarian perspectives — raising the risks of tunnel vision and major policy errors. By comparison, a capitalist free market economy driven primarily by the “collective wisdom” of market forces is often more innovative, flexible and faster to adapt to changes.
On the other hand, the Chinese government is better able to decisively implement policies that it believes will be for the greater good of the country in the long term, even if they are unpopular. Very few democratically elected governments can afford to inflict economic pain on the people and not risk being voted out in the next election — which is why most will inevitably choose short-term populist solutions over long-term good. Case in point: The US has effectively “nationalised” private sector indebtedness since the GFC, through its unorthodox (extremely loose) monetary policies and massive fiscal stimulus. The Chinese government has, thus far, eschewed helicopter money to stimulate domestic consumption.
We said China operates a competitive business environment — with a caveat: to the extent that it is allowed. For instance, the government crackdown on after-school private tutoring in 2021/22 — which it deemed to be exerting too much pressure on students, and over-commercialisation of education, which was creating undesirable inequality and accompanying social issues — sent the industry into a tailspin. Stock prices pummelled and many businesses closed, though some that survived are adapting.
Clearly, the Chinese government’s control over the private sector is not insubstantial. And many recent measures — such as tightening regulations and oversight of the consumer tech and financial industries — while positive for long-term growth sustainability, has shaken private sector confidence.
How President Xi Jinping takes the country through its current structural problems amid a widening rift with the US will determine its future economic prospects.
The investment-export-driven economic model that had served it so well for the past four decades may have run its course. China is now seen as a threat to the US’ economic and military dominance, resulting in rising tension between the world’s two largest economies. The Western world, led by the US, has turned protectionist — the use of industrial policies and trade barriers are rising — and globalisation is in reverse. China needs to expand domestic consumption as the new driver for growth. But the steep rise in household debt over the past decade and the current property sector downturn are complicating the issue.
There had been excessive speculation in real estate, perpetuated by stimulus measures and credit expansion in the aftermath of the GFC. That led to the government crackdown down in 2016 that targeted the shadow banking system, which it viewed as a rising systemic financial risk. But the measure severely affected funding for the over-leveraged property sector and led to the collapse of some of its largest developers.
It took Japan’s housing market 20 years to hit bottom — prices almost halved from the peak, and they still remain far below pre-asset bubble burst. US residential real estate prices took little over six years to reach bottom, falling about 27% after the subprime mortgage crisis — prices have since more than recovered all lost ground and are now some 70% higher than the previous peak. So far, property prices in China have fallen about 5% (for new builds) to 11% (secondary market) from the peak in mid-2021. Whether China’s real estate market plays out like the US or Japan will depend on its policy response.
China’s property bubble has similarities with the situation in Japan. The Chinese have high savings and favours investments in real estate. Prices were rapidly rising on the back of speculative activities, affecting home ownership affordability and resulting in rising household debt. Mortgages currently account for more than half of total household debts (see Chart 7). Stalled property projects hurt buyer confidence and property sales. Falling prices and a negative wealth effect, in turn, hurt consumer confidence, dampening consumption.
As it was with Japan, China is also heavily dependent on land sales for revenue to fund massive infrastructure investments and social programmes. The sharp contraction in revenue is now exerting pressure on highly indebted local governments. Youth unemployment is high and China’s Gen Z is shaping up to be more frugal, rational consumers, owing in part to growing economic uncertainties. Chinese households also have substantial credit card and retail loans that were used to fund business ventures (see Chart 7). Further deterioration in economic conditions could result in more protracted problems, especially given that current personal bankruptcy laws favour creditors and limit the ability for debt writeoffs and fresh starts.
Thus far, the Chinese government has prioritised support for developing “new productive forces” such as advanced tech and manufacturing — instead of offering steroid-like short-term solutions to boost household consumption. Its advantage is in not having to be a populist government. Nevertheless, the challenges that China faces today are undoubtedly huge, given the confluence of so many issues economically and politically.
If we had to make an educated guess today, we would say that China will not be another Japan. We believe that China as a nation is far more resilient, because of its history, than many in the West give it credit for, owing perhaps to cultural differences and lack of understanding based only on their own experiences. For this reason, we bought Tencent Holdings and the two Hong Kong property developers as the less risky route to China’s eventual recovery, for our Absolute Returns Portfolio.
For all the above reasons, we hope China will also move slightly away from its current conservative “Confucian-like” economic policies. As we said, using exports to push growth will face increasing trade restrictions. Households and private businesses (especially the property sector) are over-leveraged. Many industries have also “over-invested” to achieve scale. The government must step in aggressively, not in giving free money but in letting businesses fail — with the proviso that a “recapitalisation fund” be available and a “restructuring fund” will acquire troubled assets. Asset sales and their valuations should be done transparently — and recapitalisation for equity or convertibles should be carried out with proper governance. Why? Because China will rebound; that is beyond doubt. China is the world’s most advanced society in consumer technology.
The Malaysian Portfolio gained 0.3% for the week ended April 24. Insas-WC was up 2.2% while UOA Development gained 1.6%. The gains raised total portfolio returns to 189% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 14.1%, by a long, long way.
Meanwhile, the Absolute Returns Portfolio gained 3.8% last week, boosting total returns since inception to 0.2%. The top gainers were Tencent (+14.4%), DBS (+5.1%) and Swire Properties (+4.4%). Microsoft (-0.7%) was the only loser in our portfolio last week. We have adjusted our initial cost of investment in DBS for its 1-for-10 bonus issue.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
