Prologue: The Beginning of the Year for Asia
Back in January 2002, the consensus view on Asian markets was remarkably positive - the military action against the Taliban in Afghanistan was efficiently coming to a close, the U.S. consumer was leading the general economy out of the 2001 recession, Korean exporters and domestic consumption were steamrolling ahead and Asian equities were still trading at historically low p/e ratios even after the market bounce in the 4Q of 2001.
Asian markets began the year in much the same fashion as they ended 2001; rising substantially on the back of a major liquidity injection by central banks across the globe after September 11th. The South Korean economy, and its peoples' new love affair with the consumer credit card, was the most salient investment story coming into 2002. Unfortunately, the Korean peninsula would turn out to be the biggest story in the closing weeks of the year also. But first we will look at Japan.
The Story of Japan
During the first month of 2002 the Japanese stock markets continued to lag behind the rest of Asia and the world's developed markets. It appeared that foreign investors had become increasingly skeptical of the ruling class' ability to initiate meaningful economic reforms. People had become complacent with the view that Japan had slumped into a "jellyfish economy", i.e. one that floats with the economic cycles of the rest of the world.
There were numerous reports that local investors were purchasing large amounts of gold; the safe haven of last resort. (This incidentally helped Australian mining companies, a sector popular throughout 2001 and early 2002 among Asian hedge fund managers). The most telling anecdote of negative investment sentiment in Japan was that in January the number of investors purchasing stock on margin was less than those short-selling on margin for the first time in the market's history. With the fall of the Japanese Prime Minister Koizumi's popularity after the poorly handled firing of his Foreign Minister, it even appeared that this "last hope" (Koizumi) for change would be forced from his leadership position like so many of his predecessors.
Then, like it seems to occur every year, the market began a serious rally in the five weeks before the fiscal year end on March 31. As always, managers began to cover their shorts before the third week of March on their callable shares; however, the rush to close both callable and non-callable lent shares was spurred on by the government's "anti-deflationary" plan at the end of February; this caused one of the biggest short squeezes in three years. This fiasco was initiated by Prime Minister Koizumi's much anticipated anti-deflation plan announced at the end of February.
Much was riding on this anti-deflation plan, but it was not surprising that in the end the only "deflation" that it was meant to tackle was falling stock prices. Rather than produce a substantive program to deal with the country's economic problems, the government again propped up the markets so the banking system could remain solvent for the March year-end regulatory books. Thus, during the last week of February the Financial Services Agency (FSA), the Japanese banking industry watchdog and market regulatory agency, announced a number of rule changes for shorting stock on margin. The most significant of these was that hedge fund managers using foreign margin would no longer be able to initiate a short on the "down-tic" (the same rule applies in the United Kingdom and the United States). There were also unconfirmed reports that the FSA was forcing insurance companies, the largest lender of stock, to recall their outstanding lent shares.
These actions combined with newly released data that Japanese industrial production numbers appeared to have bottomed while most companies had extremely low inventories caused an allocation rush from global mutual fund managers into Japan (whose exposure had been underweight the country since early 2000). On the whole, Japan hedge fund managers were able to manage this short squeeze particularly well; the ABN Amro Eurekahedge Japan index was +1.1% while the TOPIX was +4.6% for March 2002.
This artificially induced upturn in the Japanese markets would hold through May; the ABN Amro Eurekahedge Japan index was +5.4% year-to-date at the end of May. Managers on the whole were well aware of the seasonality of the Japanese markets - they perform well during the first half of the year only to whither out come summer and then fall sharply through Christmas. However, most managers thought 2002 was going to be different. Even though the banking crisis had yet to be resolved, most Japan hedge fund managers believed that the rise in the previously mentioned industrial production figures, record low inventories for many companies, the perceived abatement of deflation and the flood of share buy-backs would support the market until the U.S. and European economies fully recovered.
May 24th was the yearly high for the TOPIX (1139). Over the next two months TOPIX fell by 14.34%, marking one of the worst 2 months for the Japanese markets since the bubble burst in early 1990. For the reasons discussed above, most managers came into Japan with historically high net exposures (average of between 60-65%); the market falls in June were broad-based, with every sector falling except for the paper industry. There was absolutely no place to hide on the long side. With hedge fund managers coming into June so positive, it was no surprise that the ABN Amro Eurekahedge Japan index fell 2% for the month.
With the leading indicators and fundamentals all positive, what caused the markets to decline so much over the summer? WorldCom's June 25th announcement of improperly booked capital expenses and the subsequent falls in US markets dragged all major markets lower. But the de-coupling from foreign markets that Japan hedge fund managers were expecting (or at least hoping) never materialized; suddenly the deteriorating outlook for the U.S. created too much selling pressure for even fundamentally inexpensive stocks to hold their p/e ratios. The sale orders in June were futures-led, with macro and global mutual funds leading the way (the later likely to have been facing redemptions from the U.S.).
The widespread paranoia of accounting scandals in the U.S. spread to Japan during July; when erroneous reports by sell-side analysts on perceived accounting irregularities of fundamentally sound companies caused shares to tumble limit down over successive trading days. This investor paranoia reeked havoc on fundamentally biased managers who were "whipsawed" out of long positions.
Market volatility continued throughout August and for the first time the market declines were not blamed on falling U.S. markets; it became apparent that Japan's nascent domestic led economic recovery that started earlier in the year had begun to retract. Then in September came an unprecedented announcement from the Bank of Japan (BoJ)- it would begin to buy stock directly from the banks' proprietary portfolios. This caused a sharp rise across the market in the middle part of the month. The result of this action by the BoJ was not believed to have any major effect on the available stock borrower pool. But yet again, direct government intervention caused havoc for managers trying to short sell what they believe were inept companies.
Then only a few weeks after the BoJ's stock buying scheme was announced, Prime Minister Koizumi appointed Professor Heizo Takenaka as the head of the FSA. Mr. Takenaka, a highly regarded economist and proponent of cleaning up Japan's non-performing loan problem, replaced the ineffective Hakuo Yanagisawa. The announcement was interpreted as a political shift away from the old guard of the LDP (who were unable to rectify Japan's economic problems) to a new set of advisors who understood that the bad debt problem must be solved for the Japanese economy to grow.
However, neither the BoJ stock purchasing plan nor the Takenaka announcement had much traction in producing a market rally. Managers realized that a short squeeze would not occur, and the old guard of the LDP successfully stonewalled Mr. Takenaka from making bold proposals in dealing with the banking crises. When a new economic proposal was announced on October 30th, it lacked any specific measures to improve the strength of the banking system.
It appeared that the Japanese government had for the time being lost the ability to generate market rallies; the next upswing would have to be generated from the bottom-up. This is exactly what happened in November when a number of blue-chip companies announced surprisingly strong quarterly earnings numbers. Japanese small-caps underperformed the index and Japan-only managers running "long micro/short large cap" books showed negative month-on-month returns for November. Market volatility began to decrease.
This would be a false rally as the TOPIX fell 5.5% in December, negating all gains during the previous month. Japan hedge fund managers lowered both their net and gross exposures and went on vacation; though selective technology names and REITs helped some fund's performance. The news of the North Korean government reactivating its nuclear program, though disconcerting, had no serious effect on the Japanese markets; which actually rose in the final week of the year. The ABN Amro Eurekahedge Japan index was down a marginal 0.60% for December.
Managers waited to hear the government's likely announcement early in 2003 of a decrease in the dividend tax and the replacement of Masaru Hayami (the most hated man among hedge fund managers) to head the Bank of Japan - will he be a "reformer" or from the old guard of the LDP; or does it mater?
The Story of Asia
As spring came, most of the Asian regional indices reached their highs for the year, topped by the KOSPI which hit 937 points on April 18th. The domestic consumption story and general belief during March that the U.S. economy was rebounding at a brisk path led both domestic and exporter stocks in South Korea higher.
With the statistical evidence of rising consumer demand across the region coupled with accelerating earnings momentum, increasing international fund flows to Asia and improving levels of business confidence, many Asian hedge fund managers raised their net exposure levels by April 2002 to the highest level they had been at for over a year. This renewed confidence turned out to be a trap.
During the second part of April on through the summer months, concerns over the US economy and equity markets combined with the economic and political turmoil in Argentina resulted in sharp pullbacks in several Asian markets, most notably Korea, India and Taiwan. The Korean "domestic consumption" story that many Asia including Japan hedge fund managers latched onto dissipated when the KOSPI fell 11% off its high during the last two weeks of April. The increase in tensions between Pakistan and India also hurt those managers heavily weighted in Indian software companies. During this time the one bright spot was mainland China, which continued to suck in direct investments from the United States and Europe while its domestic consumer spending rapidly grew.
During the summer months, Asian markets continued to fall and the previous expectation that the U.S. economy (led by the U.S. consumer) would lead Asia out of its doldrums switched to the belief that the U.S. and subsequently Asia were headed towards another recession by the year-end. The disappointing 2Q earnings announcement (and prediction that 3Q sales would fall) by Taiwanese semiconductor TSMC in late July blindsided investors and caused technology names to plunge further. Managers who did not aggressively lower their gross and net long exposures were hurt accordingly. The biggest draw-downs of the year for Asia including Japan managers occurred in June and July. The ABN Amro Eurekahedge Asia index fell 2.3% for those two months.
As managers came back from summer holidays, Asian markets fell further during August and September. The general sense of a strong U.S. consumer market and thus an Asian export-led recovery had largely dissipated and renewed fears of U.S. deflation continued the declines in the technology sectors. The Korean consumption story had finally reversed and the Bank of Korea persuaded local banks and financial firms to limit credit to consumers in order to prevent what officials believed was a growing credit bubble. Hong Kong continued to suffer from an overvalued currency and a falling property market; even the China stocks listed on the Hong Kong Exchange fell due to profit taking.
Managers began to realize that unlike 2001 when they saw similar market falls, there was no place to hide during the summer and fall of 2002. Even companies with solid growth and no debt were heavily sold off; and at valuations frequently below book value, it was difficult to find interesting short ideas outside of Japan. Managers continued to cut their gross exposures aggressively and actively searched for stocks with high dividend yields. Thus, there was a major shift out of technology names (which usually don't pay any dividends) and into domestic names with 5-7% dividend yields.
Markets generally quieted down during October, but terrorism came to the forefront in Asia during a month that saw the bombings of the Sari and Paddy's night clubs on the Indonesian island of Bali. Groups affiliated with Al Qaeda were later proved to be involved. The Jakarta Composite Index initially fell 11.6%, but the markets rallied after the surprising effectiveness of the Indonesian military in arresting genuine suspects and monitoring believed terrorist groups in the country. Indonesia had long become a forgotten market for most Asian hedge funds and its tribulations over October and November had no major effect on most funds.
November saw a reverse in the free-fall that Asian markets experienced through the second and third quarters; technology did well in Taiwan and South Korea with the stabilization of DRAM prices and reports of late, surging technology orders from the U.S. Generally, Asia including Japan managers traded behind the markets- managers who increased their short positions in early October were whipsawed when the markets in Korea, Hong Kong and Taiwan bounced in late October through November on better than expected earnings reports.
The naming of a new set of rulers in mid November for the Communist Party in China, including the nomination of Hu Jintao to replace Jiang Zemin as the nominal head of the Party and State was long expected and the markets took the peaceful handover favorably. This new "Fourth Generation" of leaders in China (to be formerly "elected" in March 2003) are seen as capable technocrats who will continue to lead China through market reforms.
After 11 months of continual market surprises, the biggest surprise of all would come during the last week of the year and be initiated by political developments. In South Korea, the somewhat surprising election of the liberal Roh Moo-hyun of the incumbent Millennium Democratic Party did not have a negative effect on the Korean markets. However, the confirmation from the North Korean leader Kim Jong-il's representatives to the U.S. Assistant Secretary of State James Kelley that the North Korean government had restarted its nuclear weapons program and the resulting "crisis" shocked investors. The KOSPI fell 11.5% in the last trading week of December, pulling down most Asian hedge funds with it.
Overview of the Asian Hedge Fund Industry
The overall Asian hedge fund universe performed reasonably well in 2002, with performance being in a tight range of between -5% to +10% for the year. The ABN Amro Eurekahedge index (including all strategies and regions) was +3.6%. The ABN Amro Eurekahedge Japan only index was +1.0% and the Asia ex Japan index was +7.3%.
The strategy that continued to have the best performance were Asia ex Japan distressed debt funds; which on average were up 17% for the year. Credit spreads tightened throughout Asian countries and distressed debt managers were able to find local buyers.
2002 was not a stellar year for equity long/short managers. Only the "long small cap/short blue chip technology" Japan hedge funds performed extraordinarily well. As stated above, "Jones model" equity long/short managers were caught with high net exposures during the market falls beginning in June and subsequently were unable to find interesting short ideas based on valuation metrics; unlike 2001 when finding expensive stocks to short was easy throughout the year. For the first time since 1998, stocks outside of Japan were collapsing not for fundamental reasons but because of external events.
Many uncertainties still linger today: Japan remains the only major economy without a plan of action to tackle its economic woes, war with Iraq is still looming and nuclear rumblings in North Korea need to be addressed. Though the performance of Asian markets and economies will ultimately depend on the health of the American economy, Asia is still widely believed to offer the most attractive long term opportunities for equity investors.
Lastly, there is a general belief among managers that a potential U.S. led invasion of Iraq (most believe it will occur in the coming 6 weeks) will be quick and a serious rally throughout global markets will follow. Thus, high Beta names in Asia, which are relatively inexpensive compared to their U.S. and European peers, should be where the greatest upside occurs. However, a cursory reading of military history will show that wars rarely proceed as forecasted; predicting where the world's economies and markets are headed today still remains an unpredictable game. Until the fog of war clears, Asian markets should continue on their flighty path.