RISKY
BUSINESS Ignoring Asian risk doesn't reduce
it By Jephraim P Gundzik
Asia's stock markets have performed
remarkably well in 2006. All of the region's
markets have recovered from the sudden and severe
downturn in May, which was driven by fears of
tightening global liquidity.
While gains
have flattened in Japan, South Korea and Thailand,
equities in the Philippines, India and Indonesia
have powered ahead, apparently ignoring the fact
that both domestic and
external factors are pushing
investment risk sharply higher.
The
surprisingly strong performance of Asian equities
is closely linked to the renewed vigor of US
equity markets, which have moved higher since July
in anticipation of an economic "soft landing" -
itself an increasingly risk-laden assumption. With
risk premium for stocks thin or non-existent, the
probability of a sharp and sustained correction of
equity markets in Asia and the US is increasing.
The blind eye watches at
home Domestic factors have pushed
investment risk in Thailand, the Philippines,
Indonesia and India significantly higher in 2006.
These factors will continue to elevate investment
risk in 2007. Thailand's recent military coup,
warmly described as the "Silken Coup", has
alleviated investment risk in the minds of many
investors who believe that political and social
stabilization will soon follow.
Though
Thailand has finally rid itself of the divisive
Thaksin government, its very difficult to believe
that the country's new military rulers will be
able to sustain political and social stability.
Thaksin's weak legitimacy eventually
brought him down. However, the unelected junta
that now controls the government suffers from even
weaker legitimacy. With elections postponed for at
least one year, ample time exists for social
unrest to return, especially if elections are
postponed again next year.
In the
meantime, governance will probably continue to
deteriorate, opening the door wider to
intensification of the Muslim insurgency in
southern Thailand. Political uncertainty and
social instability are likely to become an
increasing drag on economic growth. A politically
motivated crackdown on public and private sector
corruption could also weigh on economic growth.
Slower economic growth means weaker profit growth
and falling equities - the specter of which is not
discounted in valuations.
Weak legitimacy
also continues to dog the Gloria Macapagal-Arroyo
government in the Philippines, which faces pivotal
legislative elections in May 2007. Government
efforts to scrap these elections by revising the
constitution are unlikely to be condoned by the
Supreme Court. This sets the country up for one of
two political scenarios in 2007, both of which are
will provoke a further erosion of governance. In
the first scenario, the Arroyo government discards
the judgment of the Supreme Court and unilaterally
undertakes constitutional change, canceling the
2007 elections. In the second scenario, the Arroyo
government abides by the Supreme Court's decision
and legislative election go ahead.
The
first scenario will produce widespread social
unrest and greater political instability. The
second scenario will give Arroyo's opposition
greater legislative representation and revive
impeachment proceedings against the president,
also creating political instability. In addition
to increasing political and social instability,
the Philippines' domestic and foreign-supported
insurgencies are likely to continue intensifying,
further undermining already very weak governance.
The Philippines will probably pay a heavy economic
price for increasing instability and deteriorating
governance in 2007 - a price not discounted in
equity valuations.
As in the Philippines,
escalating international terrorism is also
expected to pose an increasing threat to
political, social and economic stability in
Indonesia and India in 2007. Southeast Asia's
deadliest terrorist organization, Jemaah Islamiyah
(JI), remains well-entrenched in Indonesia. Though
JI currently appears to be concentrating its
terrorist attacks on the Philippines, a renewed
burst of terrorism in Indonesia is likely over the
next several months. JI has managed successful
terrorist attacks in Indonesia annually since
2002.
The probability of a spectacular
terrorist strike is also increasing in India,
which was devastated by multiple bombings in July.
These bombings are a clear message that
Kashmir-based Muslim insurgents have returned from
battles in Iraq and Afghanistan ready to fight
India for control of Kashmir. Terrorism will
further undermine governance in India, already
weakened by government coalition politics and an
escalating domestic insurgency.
Its
impossible to find commentary on the political,
social and economic impact of terrorism and
escalating insurgencies on Asian countries in
traditional bank and brokerage research. Banks and
brokers simply don't have the resources or the
will to examine these issues - a factor that has
distorted risk perception, obliterating risk
premiums.
Goldilocks or the wolf? On top of increasing domestic investment risk,
investors also seem oblivious to external factors
that are pushing investment risk to unprecedented
heights in Asia. The diplomatic vacuum that has
characterized the Bush administration since 2000
has led North Korea down the nuclear weapons path,
the latest turn of which produced the country's
recent nuclear test.
A nuclear-armed North
Korea in itself does not necessarily elevate
security risk in Asia. However, the same cannot be
said for Washington's reaction to North Korea's
nuclear capabilities, which the Bush
administration is responsible for nurturing.
Washington's efforts to garner Security
Council support for extreme sanctions against
North Korea, including a de facto naval blockade,
are unlikely to be successful. This will force the
US to implement these extreme sanctions outside
the UN with the support of just a handful of other
countries, leading to further escalation in the
conflict between Pyongyang and Washington.
Escalation means more nuclear and missile tests by
North Korea and more saber-rattling by the US,
both of which increase the probability of a
military confrontation between the two.
There is no risk premium for South Korean
equities reflecting the increasing probability of
a military conflict on the Korean peninsula - a
conflict that could destroy South Korea's economy
in a matter of hours. Japan's equity market is
also trading in a fog. Tokyo has already imposed
more stringent economic sanctions on North Korea
in response to Pyongyang's nuclear test. The
government of Prime Minister Shinzo Abe will
almost certainly join the Bush administration's
coalition of the witless, which will try to
inspect all ocean-going freight to and from North
Korea. Such a provocation could encourage
Pyongyang to strike at Japan, which is in easy
missile range. The rapidly escalating conflict
between the US and North Korea not only increases
investment risk in South Korea and Japan, it also
elevates investment risk across Asia, which could
suffer enormous economic fallout. Another economic
risk ignored in Asia is the increasing probability
that the US economy will fall into recession in
2007. Equity markets in the US have advanced by
about 10% since July with the Dow Industrials
notching up record highs recently. This
performance is predicated on the assumption that
economic growth in the US will gently slow,
pushing inflation down and allowing the Federal
Reserve Bank to cut official interest rates.
The global equity market euphoria over a
Goldilocks economic deceleration in the US has
been fueled by the Federal Reserve, which has
refrained from further monetary policy tightening
ahead of the November mid-term elections though
inflation remains clearly on the rise. This has
created an unprecedented situation where bank
governors publicly fret about rising inflation yet
fail to tighten monetary policy appropriately - an
obvious indication of the political foundation
supporting the current monetary policy "pause".
By holding official interest rates steady,
the Fed is increasing rather than decreasing the
probability of a recession in 2007. The monetary
and psychological boost that the Fed is providing
to the US economy will inevitably quicken already
rising inflation. This will force the Fed to
aggressively tighten monetary policy after the
November elections.
The result will be a
sharp slowdown beginning in the first quarter of
2007. Given the fact that inflation is rising and
US economic activity has reaccelerated, the Fed
would be extremely lucky to manage the "soft
landing" investors are anticipating in 2007. Luck
is a very weak investment philosophy.
Asia's equity markets will blindly follow
as the DJIA in the US continues to rack up new
record highs predicated on the diminishing
probability of a soft landing despite rapidly
increasing domestic and external investment risks.
However, these gains, and much more, will
evaporate once investors' risk perceptions become
more closely aligned with actual investment risk.
The next 12 months are likely to prove extremely
volatile for equity markets in the US and Asia, as
the US economy weakens and regional instability
increases in Asia.
Jephraim P
Gundzik is president of Condor Advisers.
Condor Advisers provides investment risk analysis
to individuals and institutions worldwide. For
more information please visit
www.condoradvisers.com.
(Copyright
2006 Asia Times Online Ltd. All rights reserved.
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