Morgan Stanley Tops 2015 All-Asia Research Team

Asia will outperform all other regions of the world in real gross domestic product expansion again this year, the International Monetary Fund declared in a report issued in early May, despite the slowing Chinese economy. Many directors of Asian equity research share that optimism — along with cautionary notes about key markets.

“We expect Asia ex-Japan GDP growth of 6.5 percent in 2015, similar to the 6.5 percent in 2014,” reports Neil Perry, who oversees Asia-Pacific research at Morgan Stanley in Hong Kong. However, “domestic demand growth in most economies in the region is facing the challenges of weaker demographic trends, high debt and deflationary pressures.”

But there are exceptions. “India, the Philippines and Indonesia do not face challenges on this front and are well positioned to deliver higher rates of productive growth,” he adds. “Indeed, we are relatively bullish on the prospects of these three economies and believe that they may be able to achieve moderate to high rates of sustainable growth.”

Economists at Bank of America Merrill Lynch are slightly less sanguine. They are calling for the region’s industrial output to quicken by 6 percent this year.

“We like India for its growth in corporate earnings and long-term prospects, and Taiwan for its technology sector — despite some carry trade worries,” says Stephen Haggerty, Perry’s counterpart at Bank of America Merrill Lynch. “We believe the best exposure to Chinese equities is through derivatives and not putting your whole book to work.”

​ Other economies are more problematic. BofA Merrill analysts recommend underweighting Malaysia, owing to fiscal concerns arising from lower energy prices (the country is emerging Asia’s largest oil exporter); high consumer, corporate and government debt; minimal foreign exchange reserves to cover short-term external debt; and the possibility that its sovereign credit rating will be downgraded, he explains. The Philippines is overvalued and its currency expensive, Haggerty believes, while South Korea is saddled with high household debt, declining currency competitiveness and faltering demand from China, which accounts for 25 percent of the country’s exports.

Asset managers that invest in the region will rely on the sell side for timely updates on these and other issues affecting individual markets. The firm whose guidance they value most highly is Morgan Stanley, which captures first place for the first time in the 22-year history of the All-Asia Research Team, Institutional Investor’s exclusive ranking of the region’s best analysts. Its researchers earn a spot in all but one of the survey’s 33 sectors, missing out only on coverage of the Philippines.

Remarkably, more than half the firm’s appearances this year, 17, belong to squads deemed the best in their respective categories — that’s more than double the number of first-place finishes claimed by any other brokerage. Last year Morgan Stanley analysts turned in only seven sector-topping performances.

The firm’s ascension brings BofA Merrill’s winning streak to a halt after four years. It slips to second place, with 31 positions, one fewer than in 2014. Credit Suisse holds steady at No. 3, even though its team position total jumps by three, to 29; while UBS drops one level to fourth place, despite adding one position, bringing its total to 27. Rounding out the top five is Deutsche Bank, which advances one tier after improving its total from 21 to 24.

Survey results reflect the opinions of some 3,560 buy-side analysts and money managers at more than 1,060 institutions that collectively oversee an estimated $1.72 trillion in Asia (ex-Japan) equities. Click on the Leaders link in the navigation table at right to view the full list of 14 firms that rank this year.

China’s slowing GDP growth isn’t dampening investor enthusiasm for Chinese equities. The benchmark Shenzhen composite has been the world’s best-performing index, surging more than 60 percent in the first four months of the year, even though the nation’s economy expanded at an annualized rate of 7 percent in the first quarter — the most moderate pace in six years.

The slowdown, although widely anticipated, has prompted market observers to speculate about what steps Beijing will take to get things moving more quickly again. The People’s Bank of China has lowered its interbank lending rate twice since November — it’s now 5.35 percent — and cut banks’ reserve-requirement ratio twice since February; it currently stands at 18.5 percent.

“We expect the government to ramp up policy easing to support growth,” says Haggerty. “On the monetary front we expect additional RRR cuts of 150 basis points and rate cuts of 50 basis points this year, and other targeted credit-support measures, including increasing bank credit supply and easing loan restrictions.”

Even if economic output stabilizes, he adds, the central bank will likely continue to cut the RRR to bring it in line with requirements in other major economies. “We believe the RRR could potentially be normalized to a more sustainable level of around 10 percent in the next four to five years,” he says.

Ernest Fong, Hong Kong–based director of Asia-Pacific equity research at Credit Suisse, offers a similar forecast. “We expect more progrowth measures mainly through monetary policies,” he advises. “We expect a cut in interest rates in the second quarter, followed by another cut in interest rates and in the RRR during the summer.”

Such moves would buy time for policymakers, he contends, but do little to address the structural issues in the economy. “We still believe there is limited space for major-scale fiscal expansion, beyond the National Development and Reform Commission’s pushing forward some central government–sponsored large infrastructure projects,” he adds. “We expect local governments and state-owned enterprises to remain muted in investment amid the anticorruption campaign.”

Perry, of Morgan Stanley, believes rate and ratio cuts could be complemented by “fiscal easing in the form of corporate or household tax reduction, and the pace of that further easing to be determined in large part by labor market conditions,” he explains. “However, the overall size and scale of the stimulus is unlikely to mirror that of 2008, as policymakers are cognizant of the issues of high debt and excess capacity that arose due to the 2008 stimulus. We do not expect the Chinese authorities to devalue the renminbi.”

One major concern is the stability of the financial system, according to David Cui, who co-directs (with Ting Lu) the BofA Merrill team that captures first place for a fourth straight year for coverage of China. The country “has piled on debt in recent years, especially in the corporate sector, including local government funding vehicles,” the Singapore-based analyst says. “As economic growth slows the risk of a bad debt breakout rises sharply. Today about a third of the debt stock in China is generated in the shadow banking sector, which is poorly regulated and prone to panic. We believe that the market is grossly underestimating the chance of a financial crisis in China over the next few years.”

Cui, who also co-leads (with Ajay Kapur) the No. 2 team in Equity Strategy, says another key issue is the government’s reform program. “We are roughly halfway through the current administration’s five-year term. If we don’t see any significant progress over the next year or two, the momentum may be lost,” he warns.

An overheated property market is often identified as one of the primary causes of China’s weakening expansion. “The sector has been one of the best proxies to China’s economy, with real estate investment being a key part of its fixed-asset investment,” observes Kam Keung (Oscar) Choi, who guides the Citi team to a sixth straight victory in Property. “The sector directly and indirectly contributes 15 to 20 percent of GDP growth.”

The numbers tell the story: In late December property under construction on the mainland totaled more than 7 billion square meters of gross floor area; investment, more than 9.5 trillion yuan ($1.5 trillion); annual property sales, more than 7.6 trillion yuan; and annual land sales, roughly 4 trillion yuan, the Hong Kong–based crew chief reports.

Real estate investment slid 8.5 percent year over year in the first quarter, Choi says, and new development (as measured by gross floor area) tumbled 18.4 percent. These downturns “explain the government’s stronger-than-expected loosening for the property sector in late March — lower down payments, more tax exemptions and so on,” he says. “The central government would not want second-quarter real estate investment decelerating to zero to 5 percent and housing starts falling by a double-digit rate, which would pull down GDP significantly. More supportive measures are likely to be unveiled, and the government could continue stimulating the property sector until the physical market is more balanced and more signs of improvement emerge.”

In the meantime, better opportunities exist elsewhere. “Indonesia is at the top rung, given its more-even economic distribution and strong urbanization trends, two long-term drivers that would allow developers to continue tapping Greater Jakarta,” Choi believes. “Thailand is second, being the strongest on nearer-term measures such as household leverage and government policy, although urbanization trends are less exciting, and developers should take more urgent steps in tapping provincial demand long term.”

Malaysia and the Philippines also appear promising, the former because “the high economic concentration around Kuala Lumpur means urbanization could be focused here for some time, though affordability and policies are less supportive,” he says, while property companies in the latter “still have room to sustain growth, given their project launches and initiatives to diversify operations into new growth regions. Furthermore, their aggressive expansion of the leasing businesses should provide a more sustainable revenue base and improve margins.”

The most promising economy in the region is India’s. In mid-April the IMF raised its forecast for the nation’s GDP expansion for the current fiscal year, which began that month, by 1 point, to 7.5 percent — the world’s fastest.

Morgan Stanley’s economists are even more upbeat. “We expect growth to accelerate in India from 7.2 percent to 7.7 percent as the country benefits from the government’s reform agenda and a positive terms-of-trade effect due to lower oil and food prices,” says Perry.

In a report published last May, the firm predicted that the country was on course to increase output by 7 percent annually over the coming decade, which would likely make it one of the top five economies and stock markets in the world. “So far there have been big promises, and some good progress on reform, but there is a great deal left to do,” he asserts. “Further asset allocation to India is very likely, but the pace of it and the willingness to stay the course are going to depend on the speed and magnitude of further reform. India has shown an ability to surprise both positively and negatively on these issues, so we would expect the market to trust Prime Minister Narendra Modi’s regime — but to look for verification over time.”

Haggerty, of BofA Merrill, concurs. “India is the best long-term investment story,” he insists. “A lot of investors have already moved into India on the back of the potential for meaningful reform and infrastructure investment following the election of Modi. However, from our 19th annual India conference held in March, a common refrain from companies was that little had changed on the ground in the ten months postelection. This highlights our concern that the pace of economic recovery as well as earnings recovery could disappoint investors near term.”

Finally, there is the question of how markets across the region will react when the U.S. Federal Reserve raises interest rates, a move that could happen as early as next month. Will investors stage a rout similar to the one that accompanied word of the Fed’s plan to exit its program of quantitative easing a couple of years ago?

“We believe a correction is likely when the Fed starts to raise rates, but a much smaller one — say, 5 to 6 percent — compared to the 15 percent correction seen at the ‘taper tantrum’ of 2013,” predicts Credit Suisse’s Fong.

Among the reasons why the response won’t be as dramatic this time: Asian central banks are more likely to ease monetary policy, Asian equities are trading at a 25 percent discount to their global peers and Asian companies’ earnings-per-share revisions have beaten global EPS revisions in seven of the past nine months, he says.

Perry holds a similar view. “The region is better placed now to weather the eventual rate hikes by the Federal Reserve,” he notes.

One of the ways to assess the impact of rate increases, he adds, is to evaluate the pace at which they are expected to lift real interest rates. “In this context forecasts by both our U.S. economics team and the consensus indicate nominal policy rates are not expected to be lifted above an expected inflation rate of 2 percent, meaning that real policy rates are still expected to remain in negative territory by the end of 2016,” Perry explains. “The relatively slow pace in the expected rise in real rates is thus a mitigating factor in terms of the impact of the rate hike cycle on the region.”