MORE DOWNSIDE FOR ASIA'S EMERGING MARKETS?

Tapan Datta, Director for Emerging Markets Strategy at Schroders, shares his views on emerging markets in Asia. Two Schroders funds that offer exposure to Asia's emerging markets include the Schroder Asian Growth Fund and the Schroder Emerging Markets Fund

Vasu: Emerging markets in Asia have gone into a limbo recently after a strong rally. What's happening?

Tapan: The issue here is mainly one to do with the outlook for the global economy. The outlook improved markedly after September 11 because the Fed cut rates sharply. It stimulated consumption in the US, fuelling an impressive turnaround in the economy. That upturn lasted into the first quarter. But growth momentum faltered in the second quarter, sending export-driven Asian markets lower. There are now worries that if US stock prices continue falling sharply, this may dent economic growth in Asia. Risk aversion has gone up sharply, which is why Asian markets are currently in a limbo.

Vasu: How important is the US to the economic recovery of Asia's emerging markets?

Tapan: The US economy accounts for only one third of the global economy. But because Japan and the Europe are not doing well, the dependence on the US has become fairly high.

Vasu: What are the risks that the US economy will slow down further after a dismal second quarter? How will it impact Asia's emerging markets?

Tapan: The poor second quarter is largely priced in, but if the US economy falters further due to sharp falls in stock prices, there will be some impact on Asia's emerging markets. But in our view, this is unlikely. We think that the US economy is likely to hold steady for the next two quarters, after which growth should resume. So in the short term, there may still be more downside but on a 12-month view, Asian markets are likely to be higher compared to where they are today.

Vasu: So you don't think that Asia has decoupled from the US?

Tapan: The decoupling story is reasonable, except in the extreme scenario where US stock markets and currency markets fall sharply, sending the economy into a double dip. The probability that such a scenario will materialise is only ten per cent. So there is indeed a different story to sell for Asia. Significant changes have been made since the 1997 crisis by way of corporate restructuring and banking reforms. Domestic demand has also picked up in Asia due to liquidity and easy monetary conditions. These factors has given us a fair degree of confidence that Asia has limited downside and will avoid a recession.

Vasu: Which are the Asian market you like?

Tapan: Within our emerging markets portfolio, the markets we like most are South Korea and India. The reasons have to do with valuations, resilience of growth and underlying company performance. With India, although the politics looks volatile, many companies are doing well. The government is also embarking on a major privatisation drive which is seen as positive - it signals that India is breaking away from the stranglehold that the state had over the corporate sector. India is also not as exposed to the global economy as many other emerging Asian markets.

If the US economy does not go into a double dip, South Korea's market looks very attractive from the standpoint of economic fundamentals and valuations. South Korea is a model for Asia with its corporate reforms and improvements in return on equity. But there are risks to investing in South Korea. Aside from its exposure to the US economy, the uncertainty in IT spending and the possibility of further interest rate hikes in the face of strong domestic demand, are factors that investors should bear in mind.

Vasu: What about Taiwan?

Tapan: The economy is improving, there is a huge degree of risk aversion and consequently, high levels of cash. This is typical of a market bottom. But the difficulty with Taiwan is that it is a tech heavy market. Given the concerns about the tech sector and the risks associated with the sector, it's difficult to be entirely confident on Taiwan. The top-down for Taiwan looks good but the bottom-up looks murky. So we are sharply underweight on Taiwan given the tech heavy nature of the market.

Vasu: Any other markets you're positive about?

Tapan: We were underweight on Malaysia but we've moved this up to slightly overweight because of better macro and micro fundamentals. Its economic momentum is the strongest in Southeast Asia and in terms of financial restructuring, Malaysia is well ahead of Thailand and Indonesia. But there are some large caps in Malaysia that have high valuations relative to comparables in the region. This is why we are only modestly overweight on Malaysia.

Vasu: Your views on Thailand and Indonesia?

Tapan: We are marginally underweight on Thailand. The extent of financial restructuring has been disappointing and that will constraint the upside for the market. Thailand has done exceptionally well this year and valuations are no longer compelling.

In the case of Indonesia, there are some interesting bottom-up stories resulting from restructuring, but the political risks are high. The financial system is also unstable and it is still not back to solvency.