How deep can the bear claw?

A pedestrian checking Tokyo's Nikkei Stock Average closing information (Top-R) and other Asian stock markets at a securities office in Tokyo on Sept 4, 2015.
A pedestrian checking Tokyo's Nikkei Stock Average closing information (Top-R) and other Asian stock markets at a securities office in Tokyo on Sept 4, 2015. PHOTO: EPA

The third quarter has traditionally been volatile and this year is no exception. Asian equity markets reeled from a funds outflow triggered by the lethal combination of the economic slowdown in Asia, weak corporate earnings, the likelihood of a US rate hike this year, regional political uncertainties, low oil and commodity prices as well as weakening regional currencies.

China's surprise move to devalue the yuan ignited a bear rampage.

For the quarter-to-date, the MSCI Asia Ex-Japan Index fell 16.5 per cent while the MSCI Emerging Markets Index and South-east Asia Index fell by 15.8 per cent and 14.6 per cent respectively.

The current sell-down, however, is not a precursor to another global financial crisis or Asian financial crisis (AFC) but should test, or even exceed, the trough valuations seen during the euro zone crisis.

While the current uncertainties in Asia are not seen as a global financial crisis in the making, many investors are worried that it is reminiscent of the AFC with South-east Asian currencies' recent slump against the USD.

However, we think the probability of a full-blown AFC is low because:

•Current account balances for most Asian economies have improved - the "crisis" economies of South Korea, Malaysia, Indonesia and Thailand have a combined current account surplus of US$83 billion (S$118 billion) last year compared to a deficit of US$37 billion in 1996-97, shortly before the AFC. Only Indonesia and India are in current account deficits today, compared to seven countries in 1997. Indonesia's current account deficit is 3 per cent of GDP, the same as in 1996-97 while India's figure has widened to -2 per cent from -1 per cent.

• There is less reliance on foreign debt. With the exception of Malaysia (63 per cent last year compared to 43 per cent in 1996-97), external debt as a percentage to GDP for Indonesia, Thailand and Philippines are lower today, while that for India and South Korea are at comparable levels to the period just before AFC.

• These Asian economies have higher foreign currency reserves as a percentage of their GDPs today compared to the period just before the AFC.

NO V-SHAPED RECOVERY SEEN

While the benchmark Straits Times Index received a respite recently with a roughly 200-point rebound from 2,800 to nearly 3,000, we do not see a V-shape recovery back to July's level of 3,300 anytime soon. The uncertainties that drove equity markets lower in recent months remain very much in the forefront - uncertainties that include the impending start of the United States rate hike cycle, weak regional currencies, growth slowdown in Asia, corporate earnings uncertainties and falling oil price.

Furthermore, there is a heightened risk of a technical recession following the latest weak July industrial production figures for Singapore. It is not just manufacturing that is doing poorly. Our Singapore economist notes that the service sector also contracted by 1.1 per cent quarter on quarter in the second quarter of 2015. This sector has only ever contracted during a recession.

There is also a higher possibility that the Monetary Authority of Singapore may ease monetary policy by allowing the Singdollar to weaken at the upcoming October meeting.

The uncertainties over the past month are still present. What has changed is the stock market valuation.

Our base case: Slower growth, higher risk but not a crisis scenario. Expect STI's trading range to be within 2,750 to 3,050.

Attractive valuations underpin the STI at 2,750.

We expect earnings for stocks under our coverage to decline by 1 per cent this year, and to grow by 8.5 per cent next year. If current uncertainties drag on, there will be a downside risk to 2016 earnings. On a bottom-up basis, our 12-month base case index target is 3,200.

Our extreme negative case: Recession, rise in bankruptcies and unemployment rate, property decline accelerates, non-performing loans up. STI projection at 2,250.

While this is not our base assumption, if several negative surprises are triggered simultaneously, they could drive the equity markets' valuation down to even lower levels. These surprises could include a US stock market crash, Malaysia's central bank introducing capital controls or an even sharper devaluation in the yuan.

In such a scenario, it could push the economy into a recession, result in a rise in bankruptcies and unemployment, accelerate the decline in property prices, and push up provisions/non-performing loan levels for banks. All this could lead to a bear case STI index projection of 2,250.

BE TACTICAL DURING THIS UNCERTAIN PERIOD

The market remains fragile and susceptible to macro events unfolding over the next two months and we prefer to be tactical in our recommendations.

We prefer companies that are bombed out in the oil and gas sector (for example, Sembcorp Industries) and oil price beneficiaries such as Singapore Airlines. Venture Corp is a beneficiary of the weak ringgit and strong USD.

We continue to avoid highly geared companies, as it is a question of time before higher interest rates hit these companies.

•Yeo Kee Yan is the vice-president and retail market strategist of DBS Group Research.

It is not just manufacturing that is doing poorly. Our Singapore economist notes that the service sector also contracted by 1.1 per cent quarter on quarter in the second quarter of 2015. This sector has only ever contracted during a recession.

A version of this article appeared in the print edition of The Sunday Times on September 06, 2015, with the headline 'How deep can the bear claw?'. Print Edition | Subscribe