KostasPanagiotoualcDec03 On Liquidity

KIM ENG
Asian Liquidity Cycles

A Monthly Flow-of-Funds Guide to Asian Equity Markets
Kostas Panagiotou (65) 6336 3666 kostasp@kimeng.com

2.7
Chart of the Month

MSCI Asia Free ex-Japan Index
Market Report
2.6
Date: 23 December 2003

2.5 Log Scale
2.4
2.3
2.2
2.1 91
92
93
94
95
96
97
98
99
00
01
02
03
please see related comment on page 5
Back to 1994?
The unfolding macro-situation paints a scenario for equity markets which is similar to that of 1994. Its main elements include a major and highly synchronised surge in global demand, a downturn of the liquidity cycle and rising long and short-term interest rates. What is different between now and 1994, is the market ownership situation, which looks a lot less onerous than it was ten years ago. This should limit the downside potential on any liquidity-driven price correction. The result could be a protracted period of choppy and range-bound price action in Asian bourses.
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Regional Equity Markets
Market Report
23 December, 2003
Contents
Page Performance Tables ................................................................................................................ 3 Summary Market Ranking ....................................................................................................... 4 Back to 1994? .......................................................................................................................... 5 Asian Liquidity Matrix .............................................................................................................. 10 Hong Kong ............................................................................................................................. 12 Indonesia ................................................................................................................................ 14 Japan ..................................................................................................................................... 16 Korea ..................................................................................................................................... 18 Malaysia ................................................................................................................................. 20 Philippines .............................................................................................................................. 22 Singapore ............................................................................................................................... 24 Taiwan ................................................................................................................................... 26 Thailand ................................................................................................................................. 28 USA ........................................................................................................................................ 30 Appendix I Asian Liquidity Cycles Explained .................................................................... 32 Appendix II Flow-ofFunds Explained ................................................................................. 34
The investment conclusions in this report are based on flow-of-funds and technical analysis. Market valuation methods based on conventional criteria, such as price/earnings, price/ cashflow and price/book ratios may yield different conclusions.
KIM ENG
Market Report
23 December, 2003
Equity Markets Performance - Local Currency

Index Level Hong Kong (HSI) Indonesia (JCI) Japan (TPX) Korea (KOSPI) Malaysia (KLCI) Philippines (PCOMP) Singapore (STI) Taiwan (TWSE) Thailand (SET) USA (SPX) 12,488 674 1,015 805 775 1,421 1,722 5,835 718 1,093 1 Mth 5.5 9.3 4.2 4.4 -1.2 6.5 3.9 0.1 17.1 5.6 3 Mths 14.1 14.6 -2.7 11.9 5.2 9.1 8.4 2.7 26.9 6.9 % Change 6 Mths 12 Mths 28.3 33.2 12.3 19.3 13.2 15.5 15.5 18.6 56.6 9.8 30.5 58.5 23.4 16.4 21.3 40.9 29.0 27.6 104.9 22.0 YTD 34.0 58.7 20.4 28.2 20.0 39.5 28.4 31.1 101.5 24.2
Pricing date: 22/12/2003. Source: Bloomberg
Equity Markets Performance - US$

% Change Index Level 1 Mth 3 Mths % Change 6 Mths 12 Mths YTD
Hong Kong (HSI) Indonesia (JCI) Japan (TPX) Korea (KOSPI) Malaysia (KLCI) Philippines (PCOMP) Singapore (STI) Taiwan (TWSE) Thailand (SET) USA (SPX)
12,488 674 1,015 805 775 1,421 1,722 5,835 718 1,093
5.5 9.6 5.9 5.1 -1.2 6.7 4.8 0.1 17.7 5.6
13.9 13.7 1.7 8.2 5.1 8.1 10.1 1.7 28.1 6.9
28.7 30.3 21.8 18.9 13.2 11.8 17.2 20.1 61.4 9.8
30.9 63.2 35.5 17.0 21.3 37.1 30.9 29.8 113.4 22.0
34.4 64.1 30.9 27.5 19.9 36.1 30.0 32.8 110.2 24.2
Pricing date: 22/12/2003. Source: Bloomberg
KIM ENG
Market Report
23 December, 2003
Country Ranking Table - December 2003

Rank This Last Month Month Score* This Last Month Month Domestic Mom-Adj. Liquidity Indicators Net Capital Flows Output Gap Market Ownership
Country Malaysia Philippines Hong Kong Taiwan Indonesia Korea Singapore Thailand
Liquidity
62
62
Rising
Rising
Inflow accelerating
Negative widening Negative widening Negative narrowing Negative narrowing Negative widening Negative narrowing Negative narrowing Negative narrowing
Lightly over-owned Lightly under-owned Lightly over-owned Lightly over-owned Lightly over-owned Lightly over-owned Lightly over-owned Heavily over-owned
42
-2
Falling
Rising
Inflow accelerating
38
38
Rising
Rising
Inflow accelerating
38
38
Rising
Rising
Inflow accelerating
24
24
Rising
Peaking
Outflow decelerating
6 7
4 6
14 -10
38 0
Rising Rising
Rising Falling
Inflow decelerating Outflow decelerating
-72
-40
Falling
Falling
Outflow accelerating
17 31 38
20 31 38
Asian-8 Average Asian-8 Median Japan USA

Rising Rising Inflow accelerating Negative narrowing Negative widening Lightly over-owned Lightly under-owned
50
72
Rising
Rising
Inflow decelerating
* Ranking Scale: most attractive = +80; least attractive = -80
KIM ENG
Market Report
23 December, 2003
Back to 1994?
2004 a deja-vu of 1994
We see many parallels between the currently unfolding macro-economic environment and that of 1994. These similarities provide important clues about the likely outlook for global equity markets during the coming year. Remember that 1994 was characterised by a major decline in bond prices and trend-less equity markets (see Figure 1). For Asian equities, 1994 marked the end of the 1993 super-bull market, not with a major trend reversal, such as that of the 1997-98 Asian crisis or that of 2001, but with relatively modest declines and a marked increase in volatility (see Chart of the Month on the cover page).
Figure 1. US Stock & Treasury Bond Performance
60
US Stock and Treasury Bond Performance
40
yoy % chg
20
-20
-40
92
93
94
95
96
97
98
99
00
01
02
03
S&P500 Index
10-yr TBond (price)
The growth scare of 1994
We believe that in 1994, bonds and equities were responding adversely to a tightening of global liquidity conditions, brought about by a vigorous acceleration in the pace economic activity. In the 1992-94 period, the OECD economies were recovering from the early-1990s recession. At first, the recovery appeared patchy and fragile, but by 1994, it picked up steam unexpectedly and spread throughout the OECD region. This led to a less liquid financial environment world-wide and gave rise to an "inflationary scare", which hit bond markets particularly hard. Below, we illustrate the similarities between the current business cycle and that of 1993-94, with the use of several charts. Figure 2 shows the industrial production cycle of the US, Europe and Japan since 1993. Now, as in the early-1990s, the global economy is gradually recovering from the 2001 recession. The initial recovery stalled in the fist half of 2003, but its pace is re-accelerating as the year comes to an end.
Growth re-accelerating after a soft patch in 1H03
KIM ENG
Market Report
23 December, 2003
Figure 2. G3 Industrial Production (Trend)

10
5 6-mth annualised % chg
-5
-10
-15
93
94
95
96
97 US
98
99 EU (15)
00
01 Japan
02
03
Leading indicators point to red-hot economy in 2004
Led by the US, the OECD leading indicators of economic activity have been on a steep uptrend since early this year (see Figure 3). The leading index for the total OECD region is rising at a pace close to the peak of the 1994 cycle and will most likely move higher in the coming months. The message from the leading indicators is that the pace of global growth should strengthen considerably in the course of 2004, like it did ten years ago.
Figure 3. G3 Leading Indicators

15
6-month annualised % change
10
-5
-10 93 94 95 96 97 USA 98 99 EU-15 00 Japan 01 02 03
KIM ENG
Market Report
23 December, 2003
Figure 4. USA: SMI New Orders Index

80
70
60
50
40
30 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Manufacturing orders are rising vertically
The monthly survey of US purchasing managers, conducted by the Supply Management Institute, underlines the strength of the current recovery. In November this year, the New Orders Index of the manufacturing survey surged to levels last seen in the early-1980s (see Figure 4).
Figure 5. US New Orders of Capital Equipment (Non-defence - excl aircraft)

30 20 10 yoy % chg 0 -10 -20 -30 88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
New Orders
Trend
Capital spending is joining in the cyclical upswing
The recovery is fast spreading into the capital spending area of the economy, as shown by the double-digit growth of New Orders of Capital Equipment in the US (up 13% from a year ago in October 2003). This comes after a massive 23.5% year-on-year decline in mid-2001 (see Figure 5). The annual growth of Japanese machinery orders also surged to 13.3% in October 2003 from a cyclical low of -21.6% in October 2001.
KIM ENG
Market Report
23 December, 2003
Figure 6. US Yield Curve

4
3 Percentage Points
-1 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
The steepness of the yield curve is as pronounced as it was in the early 1990s
The current steep upward slope of the US yield curve (which is the spread between long and short-term interest rates), also confirms the bullish message of the other leading indicators of the business cycle. Over the last two years, the spread between the 10-year Treasury bond yield and the 3-month Treasury note expanded in a very similar fashion to that of the early-1990s, which foreshadowed the 1994 surge in economic activity world-wide (see Figure 6).
Figure 7. US Interest Rates
10
6 % 4 2 0 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
3-Mth T Bill
10-Yr T Bond
Interest rates waiting for take off
The underlying interest rate structure that brought about the positive widening of the yield curve is again very similar to that of 1993-94. In response to the 2001 recession and the subsequent feeble recovery, short-term rates are bottoming out, after a long period of decline. Long-term rates have started to move higher in a measured way, reflecting current uncertainty of market participants about the sustainability of the economic expansion (see Figure 7). We expect short-term interest rates to start rising by mid-2004, as the firming of economic recovery will deprive central banks of any justification for continuing with their current loose monetary policies. Bond yields should also move higher during the course of the year, as the uncertainty about the strength of the recovery gives way to a growth scare and an associated inflationary scare. However, even before we see the lifting of official interest
KIM ENG
Market Report
23 December, 2003
rates, the global pool of excess capital should start to dissipate on the back of increased capital spending that is staring to accompany the cyclical upswing. The expected monetary tightening will simply speed up the depletion of liquidity, which by then would be underway.
Figure 8. S&P500 Earnings Per Share
60
40
20 yoy % chg
0 -20
-40
-60
89
90
91
92
93
94
95
96 EPS
97
98 Trend
99
00
01
02
03
Will earnings save the rally?
What about earnings? Surely company profits are on the rise and should continue to grow in line with the accelerating pace of economic recovery. Wouldnt rising profits improve equity valuations and keep the stock market rally going? Not necessarily. In the absence of rising liquidity, improved earning fundamentals may not be able to sustain the rally. In fact, the earnings up-cycle of the early 1990s did not peak until 1995 (see Figure 8). Moreover, the subsequent slowdown of earnings growth during the mid-1995 to mid1998 period did not prevent the major bull-market in US equities from taking hold. There is simply no consistent relationship between the corporate profit cycle and equity market indices. In our view, the liquidity cycle is the main determinant of stock markets movements (see Appendix II). The unfolding macro-situation paints a scenario for equity markets similar to that 1994. Its main elements include a major and highly synchronised surge in global demand, a downturn of the liquidity cycle and rising long and shortterm interest rates. The end of the liquidity up-cycle should come about by the increased funding needs of the expanding economy and the tightening action of major central banks in the OECD and Asia. What is different between now and 1994, is the market ownership situation, which is a lot less onerous than it was ten years ago. In absolute terms, the ratio of the market capitalisationto-quasi money is now much lower than it was in early-January 1994, which marked the peak of the 1993 rally in Asian equities. In relative terms, the position of the ratio relative to its long-term trend line places the market ownership indicators at the lightly over-owned section of their respective charts (see Figures 5 & 6 of individual countries at the County Profiles section of this report). The only notable exception is Thailand, with her market ownership indicator well into the heavily over-owned area of its chart. We expect the relatively undemanding levels of Asian market ownership to limit the downside potential of any price correction, which may arise from the more difficult liquidity environment ahead. The result could well be a protracted period of choppy and range-bound price action in the regional bourses.
Declining liquidity and relatively undemanding market ownership could produce choppy and trend-less equity markets
KIM ENG
Market Report
23 December, 2003
Asian Liquidity Matrix - December 2003

Domestic Liquidity Index
Status Rising Peaking Falling Bottoming Out Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
n n
n n
Momentum-Adjusted Liquidity Index

Status Rising Peaking Falling Bottoming Out Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
n n
n n
n n
Net Capital Flows

Status Inflow Accelerating Inflow Decelerating Outflow Accelerating Outflow Decelerating Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
n n n
n n n
Output Gap
Status Negative Widening Negative Narrowing Positive Widening Positive Narrowing Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
n n n
n n n n
Market Ownership
Status Heavily Under-owned Lightly Under-owned Lightly Over-owned Heavily Over-owned Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand
n n n n n n n n
10
KIM ENG
Market Report
23 December, 2003
Country Profiles
11
KIM ENG
Market Report
Hong Kong
Figure 1 : Hang Seng Index
4.3
Current Previous Rank 3 2 Score 38 38 Asian-8 Median 31 31
23 December, 2003
4.2
Both domestic and external liquidity conditions remain very supportive of Hong Kongs equity prices.
Log Scale
4.1
4.0
3.9
3.8 95
96
97
98
99
00
01
02
03
Figure 2 : Domestic Liquidity Conditions

150 140
The domestic liquidity index is rising, together with its leading indicator, the momentum-adjusted index.
130 120 Level 110 100 90 80 70 95 96 97 98 Liquidity Index 99 00 01 02 03 Momentum-Adjusted
Figure 3 : Net Capital Flows

40
30
20
Hong Kongs capital account surplus is rising at an accelerating pace.
Index
10
-10
-20
95
96
97
98
99
00
01
02
03
12
KIM ENG
Market Report
23 December, 2003
Figure 4 : Output Gap

1.5
Above Trend >> << Below Trend
1.0
The economy continues to operate below trend, but the amount of excess capacity has been diminishing steadily over the last two years.
0.5
0.0
-0.5
-1.0
-1.5
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
Figure 5 : Market Cap/Quasi Money Ratio

2.0 1.8 1.6
The market cap/quasi money ratio is has been moving up rapidly, increasing its distance from its long-term trend and
1.4 Times 1.2 1.0 0.8 0.6 0.4 0.2 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 MC/QM Ratio Long-Term Trend
Figure 6 : Market Ownership

2.0 Over-owned >> << Under-owned 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
lifting the market ownership indicator towards the upper end of the lightly over-owned region of the chart.
13
KIM ENG
Market Report
Indonesia
2.9
Current Previous Rank 5 5 Score 24 24 Asian-8 Median 31 31 Figure 1 : Jakarta Composite Index
23 December, 2003
2.8
Indonesias domestic liquidity conditions are becoming slightly less favourable, but external fund flows are improving.
Log Scale
2.7
2.6
2.5
2.4
95
96
97
98
99
00
01
02
03

160 140
The domestic liquidity index continues to advance, but the momentum-adjusted liquidity index appears to be peaking.
120 Level 100 80 60 40 95 96 97 98 99 00 01 02 03
Liquidity Index
Momentum-Adjusted

1.5
1.0
The capital account is in deficit, but the pace of outflow is decelerating.
US$bn
0.5
0.0
-0.5
-1.0
95
96
97
98
99
00
01
02
03
14
KIM ENG
Market Report
23 December, 2003

2.0 Above Trend >> << Below Trend 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
The underlying conditions for domestic liquidity are favourable, as the economy operates with an expanding negative output gap.

1.2
1.0
The market cap/quasi money ratio has been hovering above its long-term trend line...
Times
0.8
0.6
0.4
0.2
93
94
95
96
97
98
99
00
01
02
03
MC/QM Ratio
Long-Term Trend

2.0 Over-owned >> << Under-owned
1.5
placing the market ownership indicator well within the lightly overowned range.
1.0
0.5
0.0 93 94 95 96 97 98 99 00 01 02 03
15
KIM ENG
Market Report
Japan
Figure 1 : Tokyo TOPIX Index
3.25 3.20 3.15
23 Current Previous December, 2003 Score 38 38
Log Scale
Japanese equities are facing a favourable set of liquidity fundamentals.
3.10 3.05 3.00 2.95 2.90 2.85
95
96
97
98
99
00
01
02
03

180
160
The domestic liquidity index has finally turned up, following an earlier turnaround of its momentum-adjusted counterpart.
140 Level 120 100 80 95 96 97 98 Liquidity Index 99 00 01 02 03 Momentum-Adjusted

15
10
The pace of net capital inflows is accelerating at a furious pace.
US$bn
-5
-10
-15
95
96
97
98
99
00
01
02
03
16
KIM ENG
Market Report
23 December, 2003

1.5 Above Trend >> << Below Trend
1.0
Japan s negative output gap has been diminishing, but it remains sufficiently large to support the rising pool of domestic liquidity.
0.5
0.0
-0.5
-1.0
-1.5
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

1.8 1.6 1.4
The market cap/quasi money ratio is cruising above its long-term trend
Times
1.2 1.0 0.8 0.6 0.4
80
82
84
86
88
90
92
94
96
98
00
02
MC/QM Ratio
Long-Term Trend

1.8 Over-owned >> << Under-owned 1.6 1.4 1.2 1.0 0.8 0.6 0.4 80 82 84 86 88 90 92 94 96 98 00 02
placing the market ownership indicator into the middle of the lightly over-owned section of the chart.
17
KIM ENG
Market Report
Korea
Figure 1 : KOSPI Index
3.1 3.0 2.9
23 December, 2003
Korean domestic liquidity flows continue to improve, but external fund flows are becoming less supportive of equity prices.
Log Scale
2.8 2.7 2.6 2.5 2.4 95 96 97 98 99 00 01 02 03

200 180 160
Both the domestic liquidity index and the momentumadjusted index are heading north, with the latter leading the way.
140 Level 120 100 80 60 40 95 96 97 98 99 00 01 02 03
Liquidity Index
Momentum-Adjusted

3 2 1 US$bn 0 -1 -2 -3 -4
Koreas capital account surplus is now shrinking.
95
96
97
98
99
00
01
02
03
18
KIM ENG
Market Report
23 December, 2003

Times 0.4 0.2 0.0 91 92 93 94 95 96 97 98 99 00 01 02 03 MC/QM Ratio Long-Term Trend
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
The rate of capacity utilisation has been rising, but not fast enough to derail the upswing of the domestic liquidity cycle.

1.0
0.8
The market cap/quasi money ratio has been rising above its long-term trend line
0.6

2.0
placing the market ownership indicator within the lightly over-owned section of the chart.
1.5
1.0
0.5
0.0
91
92
93
94
95
96
97
98
99
00
01
02
03
19
KIM ENG
Market Report
Malaysia
Figure 1 : KLSE Composite Index
3.2 3.1 3.0
23 December, 2003
The KLSE is facing a favourable combination of domestic and external liquidity conditions.
Log Scale
2.9 2.8 2.7 2.6 2.5 2.4 95 96 97 98 99 00 01 02 03

130
120
The momentum-adjusted index is above the domestic liquidity index and they are both moving higher.
110 Level 100 90 80 95 96 97 98 Liquidity Index 99 00 01 02 03 Momentum-Adjusted

1.5
1.0
0.5
Internationally mobile capital is flowing into Malaysia at an accelerating pace.
US$bn
0.0
-0.5
-1.0
-1.5
95
96
97
98
99
00
01
02
03
20
KIM ENG
Market Report
23 December, 2003

Times
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0
Malaysias large and growing negative output gap is the ultimate source of domestic liquidity.
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

4.5 4.0 3.5
The market cap/quasi money ratio is rising above its long-term trend line...
3.0 2.5 2.0 1.5 1.0 0.5 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 MC/QM Ratio Long-Term Trend

2.0
placing the market ownership indicator at the upper end of the lightly over-owned section of the chart.
1.5
1.0
0.5
0.0 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
21
KIM ENG
Market Report
Philippines
3.6 3.5
Current Previous Rank 2 7 Score 42 -2 Asian-8 Median 31 31
23 December, 2003
Figure 1 : Philippines Composite Index
Domestic liquidity has been shrinking, but favourable external fund flows enabled the Manila bourse to participate in the regional stock market rally of 2003.
3.4 Log Scale 3.3 3.2 3.1 3.0 2.9
95
96
97
98
99
00
01
02
03

130
120
The domestic liquidity index remains on a downtrend, but its leading indicator, the momentum-adjusted index is pointing to a more liquid financial environment in the coming months.
110 Level 100 90 80 95 96 97 98 99 00 01 02 03
Liquidity Index
Momentum-Adjusted

1.5
1.0
0.5
Net capital flows are moderately positive and the pace of inflow is accelerating.
US$bn
0.0
-0.5
-1.0
-1.5 95 96 97 98 99 00 01 02 03
22
KIM ENG
Market Report
23 December, 2003

Times
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
The economy operates below trend and the rate of capacity utilisation is decreasing.

4.0 3.5 3.0
The market cap/quasi money ratio is in line with its longterm trend
2.5 2.0 1.5 1.0 0.5 90 91 92 93 94 95 96 97 98 99 00 01 02 03
MC/QM Ratio
Long-Term Trend

2.0
1.5
placing the market ownership indicator to the upper end of the lightly under-owned range.
1.0
0.5
0.0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
23
KIM ENG
Market Report
Singapore
3.4
23Current Previous December, 2003

Rank 7 Score -10 Asian-8 Median 31 Figure 1 : Singapore Straits Times Index 6 0 31
Singapores liquidity profile is favourable, but there are hints of a less liquid financial environment in the period ahead.
3.3
Log Scale
3.2
3.1
3.0
2.9 95
96
97
98
99
00
01
02
03

130 120
The domestic liquidity index remains on an up-trend. However, the momentumadjusted index has turned down, indicating a less hospitable liquidity landscape in the coming year.
110 Level 100 90 80 70 95 96 97 98 99 00 01 02 03
Liquidity Index
Momentum-Adjusted Index

0.5
0.0
-0.5
External liquidity flows are moderately supportive of equity prices, as Singapores net capital outflow is decelerating.
US$bn
-1.0
-1.5
-2.0
-2.5
95
96
97
98
99
00
01
02
03
24
KIM ENG
Market Report
23 December, 2003

Times
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0
The economy continues to operate with a negative output gap, but the rate of capacity utilization has been edging higher over the last two years.
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

2.0 1.8 1.6 1.4
The market cap/quasi money ratio is moving higher and away from its long-term trend line
1.2 1.0 0.8 0.6 0.4 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
MC/QM Ratio
Long-Term Trend

1.8 Over-owned >> << Under-owned 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 84
placing the market ownership indicator into the middle of the lightly over-owned zone.
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
25
KIM ENG
Market Report
Taiwan
Figure 1 : Taiwan Weighted Index
4.1 4.0
23 December, 2003
Taiwan equities continue to enjoy strong support both from domestic and external liquidity flows.
3.9 Log Scale
3.8
3.7
3.6
3.5 95
96
97
98
99
00
01
02
03

150 140 130
The liquidity index and its leading indicator, the momentum-adjusted index, are heading north.
120 Level 110 100 90 80 70 95 96 97 98 99 00 01 02 03
Liquidity Index
Momentum-Adjusted

6
The pace of net capital inflow is accelerating at a furious pace.
2 US$bn 0 -2 -4 95
96
97
98
99
00
01
02
03
26
KIM ENG
Market Report
23 December, 2003

Times
1.0
Taiwans negative output gap has been narrowing, but there is plenty of slack left to accommodate a rising pool of excess capital in the domestic financial system.
0.5
0.0
-0.5
-1.0
-1.5
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

2.5
2.0
The market cap/quasi money ratio has been rising above its long-term trend
1.5
1.0
0.5
0.0
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 MC/QM Ratio Long-Term Trend

3.5 Over-owned >> << Under-owned 3.0 2.5 2.0 1.5 1.0 0.5 0.0
placing the market ownership indicator within the lightly over-owned range of the chart.
84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
27
KIM ENG
Market Report
Thailand
Figure 1 : Bangkok SET Index
3.2
Current Previous Rank 8 8 Score -72 -40 Asian-8 Median 31 31
23 December, 2003
3.0
The Bangkok market continues to outperform the other regional bourses, but Thailands liquidity conditions are starting to worsen.
Log Scale
2.8
2.6
2.4
2.2 95 96 97 98 99 00 01 02 03

130
120
Both the domestic liquidity index and its momentumadjusted derivative index have turned down.
Level
110
100
90
80
95
96
97
98
99
00
01
02
03
Liquidity Index
Momentum-Adjusted

3
Thailands capital account deficit has been narrowing rapidly for most of this year, but the pace of capital outflow is starting to accelerate.
US$bn 0 -1 -2 95
96
97
98
99
00
01
02
03
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KIM ENG
Market Report
23 December, 2003

Times
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0
The Thai economy continues to operate below trend, with the negative output gap getting gradually narrower since early 2002.
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

1.8 1.6 1.4
Even though the market cap/ quasi money ratio has been rising together with its longterm trend line, the distance between them is expanding rapidly
1.2 1.0 0.8 0.6 0.4 0.2 0.0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
MC/QM Ratio
Long-Term Trend

2.0
sending the market ownership indicator deep into the heavily overowned region of the chart.
1.5
1.0
0.5
0.0 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03
29
KIM ENG
Market Report
USA
23 December, 2003
Current Previous
Score
50
74
Figure 1 : Standard & Poor 500 Index

3.2
3.1
Domestic liquidity conditions remain positive for US equities, but external fund flows are starting to worsen.
3.0 Log Scale
2.9
2.8
2.7
2.6 95
96
97
98
99
00
01
02
03

110
The domestic liquidity index is edging up, following a much earlier turnaround of its leading indicator, the momentum-adjusted liquidity index.
105
Level
100
95
90 95 96 97 98 Liquidity Index 99 00 01 02 03
Momentum Adjusted

140 120 100
The pace of net capital inflows into the US is staring to decelerate, on the back of much reduced purchases of US securities by foreign investors.
US$bn
80 60 40 20 0
95
96
97
98
99
00
01
02
03
30
KIM ENG
Market Report
23 December, 2003

0.8 0.6 0.4 0.2 0.0 << Below Trend -0.2 -0.4 -0.6 -0.8
The US economy continues to operate with a large negative output gap.
Above Trend >>

Times
82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

3.0
2.5
The market cap/quasi money ratio has been rising towards its down-sloping long-term trend
2.0
1.5
1.0
0.5
74
76
78
80
82
84
86
88
90
92 Trend
94
96
98
00
02
MC/QM Ratio

1.2
placing the market ownership indicator into the lightly under-owned section of the chart.
1.0
0.8
0.6
0.4
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
31
KIM ENG
Market Report
23 December, 2003
Appendix I: Asian Liquidity Cycles Explained

This report assess the absolute and relative attractiveness of Asian equity markets on the basis of liquidity conditions prevailing and likely to prevail in each country. The following markets are covered: Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan, Thailand and the USA. As our main focus is ex-Japan Asia, Japan and the USA are not ranked, but are included for reference only. Five flow-of-funds indicators are used to derive a single score for each country, which allows us to compare equity markets on the basis of their liquidity fundamentals. The score ranges from +80 (most attractive) to -80 (least attractive). To derive the score, the following indicators are weighted according to their importance in shaping the overall liquidity environment: Domestic Liquidity Index: A proprietary index constructed from a number of monetary and credit aggregates. The index captures changes in the availability of excess capital in the domestic financial system. Excess capital is defined as the portion of financial resources in the system which exceeds the funding requirements of the real economy. Momentum-Adjusted Liquidity Index: A leading indicator of domestic liquidity conditions. It is derived from adjusting the Domestic Liquidity Index by a momentum factor, which captures the speed by which liquidity conditions are improving or deteriorating. Net Capital Flows: The net amount of capital flows from abroad, derived from balance of payments statistics. This measure captures all categories of capital flows: official, private, foreign direct investment, portfolio, bank lending, as well as errors & omissions. Obviously, we like countries with accelerating capital inflows and dislike those with accelerating capital outflows. Between decelerating outflows and decelerating inflows we prefer the former. This is because equity markets tend to perform better when outflows are getting smaller than when inflows are getting smaller. Output Gap: It measures the amount by which an economy operates above (i.e. positive output gap) or below (i.e. negative output gap) its long-term growth potential. The state of the output gap strongly influences the liquidity conditions prevailing in each country. Liquidity tends to expand when the output gap is negative and contract when it is positive. Numerous studies have shown that equities perform consistently better when the economy operates with a sizeable amount of spare capacity. Market Ownership: This is the valuation model of the flow-of-funds analysis. We use a ratio of stock market capitalisation over quasi-money (i.e. interest-bearing deposits in the banking system) to capture the aggregate asset allocation between equities and cash. We then take the percentage deviation of this ratio from its long-term trend to derive a Market Ownership value. An equity market is considered heavily over-owned when the market ownership value is at the
32
KIM ENG
Market Report
23 December, 2003
upper end of its historical range and heavily under-owned when is at the lower end of this range. Over-owned markets are more vulnerable to a downturn of the liquidity cycle than under-owned ones. Conversely, during an upswing of the liquidity cycle, under-owned markets have greater upside potential than overowned ones. Most Attractive: To attain the top score (+80), a country has to have all of the following: Rising domestic liquidity index, rising momentum-adjusted liquidity index, increasing net capital inflows, a widening negative output gap and a heavily under-owned equity market. Least Attractive: The lowest score (-80) goes to countries which have all of the following: Declining domestic liquidity index, declining momentum-adjusted liquidity index, increasing net capital outflows, a widening positive output gap and a heavily overowned equity market.
33
KIM ENG
Market Report
23 December, 2003
Appendix II: Flow-of-Funds Explained

Buffetts Wisdom At Berkshire we focus almost exclusively on the valuations of individual companies, looking only to a very limited extent at the valuation of the overall market. Even then, valuing the market has nothing to do with where its going to go next week or next month or next yearThe fact is that markets behave in ways, sometimes for a very long stretch, that are not linked to value. Warren Buffett. From Mr. Buffett on the Stock Market; article in FORTUNE magazine, Nov 22, 1999. This simple, but important observation by the world greatest value investor is routinely ignored by most market strategists, who use valuation methods designed for stock picking to predict the next move of the stock market index. It is not that value is irrelevant to markets. As Buffett says in the same article: Sooner or later, though, value counts. But value becomes more relevant to market movements the further away we move from the sooner towards the later. In the short to medium term (6-12 months) the power of value on the market is superseded by the power of money. More specifically, by the availability of money that can be invested in financial assets. Cheap markets can become cheaper when the pool of investable funds shrinks, while expensive markets can become even more expansive when there is an abundance of capital for the purchase of securities. Below we explain the Flow-of-Funds approach to investing with some reference to conventional market valuation methods that most investors are familiar with. A Monetary Phenomenon It has long been accepted that consumer price inflation is a monetary phenomenon, in the sense that it originates from changes in the monetary rather than the real side of the economy. The flow-of-funds approach to investing stems from the proposition that asset price cycles are monetary phenomena, very much like the price cycles of consumer goods. It is simply a case of too much money chasing too few apples, equities or bonds. When this happens, the respective prises of these items will tend to rise. Conversely, prices will tend to fall when too many apples, equities or bonds have to compete for a shrinking pool of money. Stocks and Bonds as a Store of Savings The liquidity approach realises that financial assets act primarily as a store of accumulated income (i.e. savings). When, for whatever reason, savings rise, so does the demand for and the price of - financial assets. Their price is particularly responsive to savings-driven demand, which tends to change a lot faster than their primary supply. Based on these considerations, the flow-of-funds approach focuses on the factors that influence the availability of funds that can be invested in equity and bond markets.
34
KIM ENG
Market Report
23 December, 2003
Fluctuating Capital The conventional valuation approach implicitly assumes that there is a fairly fixed amount of capital dedicated to investment in financial assets. When investors realise that equity market A offers better value than market B, money will leave market B for market A. Prices in market A will rise and those in market B will fall. Equilibrium of some sort will be restored. The object of the exercise then becomes to discover the market(s) with the most attractive valuations before other investors do. However, we often see markets deemed to be expensive moving from strength to strength and markets perceived as cheap stagnating or become even cheaper. The fact that markets quite often refuse to comply with perceived valuation fundamentals suggests that the implicit, but crucial, assumption of a fixed amount of investable capital is not realistic. In real life, liquidity (i.e. the amount of capital available for investment in financial assets) fluctuates over the course of the business cycle. Misguided Application of a Sound Approach Reflecting their relative fundamental strength, some stocks perform better than others, irrespective of the general direction of the market. Conventional valuation methods are an indispensable tool for anticipating the relative performance of individual stocks (i.e. stock A versus stock B). However, they are not particularly helpful in forecasting the short and medium term direction of the equity market. By applying valuation techniques designed for individual stock selection on the stock market as a whole, the conventional wisdom invariably views an expanding economy as positive and a slow or recessed economy as negative for equity prices. If investors buy stocks for their earnings stream, strong economic growth should translate into strong earnings and increase their appeal to the investing public. An earnings-destroying recession gives rise to opposite sentiments. Equity-Friendly Recessions and Equity-Hostile Expansions However, historical experience suggests that rising equity prices and strong economies do not always go hand in hand. Equity markets tend to perform strongly half way through a recession and the early stage of the economic recovery and perform poorly during the tail end of the economic expansion. This timing discrepancy is typically explained as a discounting process, where far-sighted equity prices efficiently discount the good news of the emerging economic upswing, as well as the bad news of the impending economic downturn. The flow-of-funds approach sees things differently. It considers the lagged relationship between equity prices and the business cycle not as one of foresight, perfect or otherwise, but one of liquidity. There are simply more funds available to be invested on paper assets during the tail end of a recession than there are during the tail end of an expansion. To understand why we have to look at the factors that cause liquidity to expand and contract in a fairly regular cyclical fashion.
35
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Market Report
23 December, 2003
A Hydraulic Definition of Liquidity Simply defined, liquidity is the amount of money in the financial system that exceeds the financing needs of economy. The funding needs of the economy are set by the growth rate of nominal output, while the local central bank determines the supply. When more money is supplied than the economy can absorb, there is a build up of surplus capital, much of which finds its way into financial asset markets.
Bond / Equity Markets
Central Bank
Domestic Liquidity Pool
Real Economy
Global Financial System
Think of the pool of domestic liquidity as a reservoir connected through a network of pipes with: (1) the local central bank, (2) the countrys economy, (3) the global financial system and (4) the local bond and equity markets (see diagram above). The direction and intensity of fund flows through this hydraulic system changes over the course of the business cycle. Recession Hydraulics During a recession, the reservoir receives large amounts of liquidity from the central bank, as the latter eases monetary policy. The idea behind the monetary easing is to kick-start a recovery by extending cheap credit to the economy. However, the central bank cannot lend directly to the non-bank private sector. All it can do is raise the reserves and deposit liabilities of the banking sector and hope that the banks will start lending to the non-bank private sector. Its hopes are initially frustrated because recessions have a habit of raising the perceived credit risk sky-high and sharply reducing profitable investment opportunities. As a result, banks become extremely reluctant to lend and the private sector equally reluctant to borrow. The pool of liquidity rises and overflows into bond and equity markets. Asset prices advance, giving the impression that the market correctly anticipates the cyclical prosperity ahead.
36
KIM ENG
Market Report
23 December, 2003
Late Expansion Hydraulics During the late stage of a cyclical expansion, perceived risks are low and credit expands at a furious pace, driven by strong investment spending. Capacity constraints start to develop, prompting the central bank to tighten monetary policy. With the economy and the central bank both draining the pool of excess capital, financial asset markets are eventually starved of liquidity. Asset prices retreat, well before the flow of economic and earnings statistics turns bearish. Mid-Expansion Rallies In the previous two paragraphs we described liquidity conditions at or close to the turning points of the business cycle. What happens in-between? Mid-expansion rallies in bond and equity markets are rather common, even though they tend to lack the vigour of their early-cycle cousins. Often, several quarters into an economic recovery, economic growth rates start to decelerate, raising fears of recession. To these, central banks tend to respond with expansionary monetary policies, which help to replenish the pool of liquidity and drive up asset prices. Global Liquidity and Net Capital Flows The size of private cross-border capital flows has increased tremendously since the late1980s. So has their impact on bond and equity markets, especially those of emerging economies. The amount of capital that crosses international borders at any point in time, roughly corresponds to the ups and downs of the global liquidity cycle (defined in the same way as its domestic counterpart). This is because perceptions of risk of investing abroad are strongly influenced by the changing availability of capital on a global scale. When the global liquidity cycle is on an uptrend, the perceived risk of offshore investing declines. International capital flows rise, as foreign investors become less discriminating in their choice of countries or regions. Conversely, when the global liquidity cycle is on a downturn, risk premiums rise and countries or regions with questionable macrofundamentals tend to suffer punishing capital outflows.
Private Net Capital Flows to Emerging Countries
250 200 150 US$bn 100 50 0 -50 72 74 76 78 80 82 84 86 88 90 Source: IMF 92 94 96 98 00 02
37
KIM ENG
Market Report
23 December, 2003
Net Capital Flows and Domestic Liquidity The effect of net capital flows on the domestic pool of excess capital depends very much on the countrys foreign exchange regime and the actions of the central bank. When the authorities operate a free-floating system, a capital inflow (outflow) will simply represent an addition (subtraction) to the domestic amount of investable funds. However, under a regime of pegged exchange rates, not supported by a currency board a la Hong Kong, a change in the direction of capital flows can have a disproportionately large impact on domestic liquidity. This is because the central bank will try to resist the upward (downward) pressure on the currency generated from incoming (outgoing) capital. Unless it is fully sterilised, the foreign exchange intervention will involve a rise (fall) in official external reserves and a corresponding increase (decline) in the domestic money supply. This is indeed the case in most developing countries, where inadequate monetary tools at the disposal of central banks (such as minuscule and thinly traded domestic bond markets) hamper fully sterilised forex intervention.
38
KIM ENG
Market Report
23 December, 2003
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Regional Equity Markets

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KIM ENG

Asian Liquidity Cycles

Kostas Panagiotou (65) 6336 3666 kostasp@kimeng.com

Chart of the Month

Date: 23 December 2003

please see related comment on page 5

Regional Equity Markets

Equity Markets Performance - Local Currency

Pricing date: 22/12/2003. Source: Bloomberg

Equity Markets Performance - US$

Pricing date: 22/12/2003. Source: Bloomberg

Country Ranking Table - December 2003

Inflow decelerating Outflow decelerating

Asian-8 Average Asian-8 Median Japan USA

* Ranking Scale: most attractive = +80; least attractive = -80

US Stock and Treasury Bond Performance

10-yr TBond (price)

The growth scare of 1994

Growth re-accelerating after a soft patch in 1H03

Figure 2. G3 Industrial Production (Trend)

5 6-mth annualised % chg

Leading indicators point to red-hot economy in 2004

Figure 3. G3 Leading Indicators

6-month annualised % change

-10 93 94 95 96 97 USA 98 99 EU-15 00 Japan 01 02 03

Figure 4. USA: SMI New Orders Index

Manufacturing orders are rising vertically

Figure 5. US New Orders of Capital Equipment (Non-defence - excl aircraft)

Capital spending is joining in the cyclical upswing

Figure 6. US Yield Curve

Interest rates waiting for take off

Will earnings save the rally?

Asian Liquidity Matrix - December 2003

Momentum-Adjusted Liquidity Index

Net Capital Flows

Current Previous Rank 3 2 Score 38 38 Asian-8 Median 31 31

Figure 2 : Domestic Liquidity Conditions

130 120 Level 110 100 90 80 70 95 96 97 98 Liquidity Index 99 00 01 02 03 Momentum-Adjusted

Figure 3 : Net Capital Flows

Hong Kongs capital account surplus is rising at an accelerating pace.

Figure 4 : Output Gap

Above Trend >> << Below Trend

Figure 5 : Market Cap/Quasi Money Ratio

Figure 6 : Market Ownership

Figure 2 : Domestic Liquidity Conditions

120 Level 100 80 60 40 95 96 97 98 99 00 01 02 03

Figure 3 : Net Capital Flows

The capital account is in deficit, but the pace of outflow is decelerating.

Figure 4 : Output Gap

Figure 5 : Market Cap/Quasi Money Ratio

Figure 6 : Market Ownership

23 Current Previous December, 2003 Score 38 38

Japanese equities are facing a favourable set of liquidity fundamentals.

3.10 3.05 3.00 2.95 2.90 2.85

Figure 2 : Domestic Liquidity Conditions

140 Level 120 100 80 95 96 97 98 Liquidity Index 99 00 01 02 03 Momentum-Adjusted

Figure 3 : Net Capital Flows

The pace of net capital inflows is accelerating at a furious pace.

Figure 4 : Output Gap

Figure 5 : Market Cap/Quasi Money Ratio

1.2 1.0 0.8 0.6 0.4

Figure 6 : Market Ownership