Analysis: Asia's post-September market rally runs out of gas

By Vidya Ranganathan

SINGAPORE (Reuters) - Investors' appetite for emerging Asia stocks, bonds and currencies is spent, and for reasons that go beyond the overriding question of when and how the U.S. Federal Reserve will reverse its loose policies.

Dissatisfied with the economic recovery in the region, disappointed with corporate earnings and worried that currencies have little room to rally further, investors seem to be abandoning the rally that was spurred in mid-September by the Fed's decision not to start tapering its stimulus.

"We need to see much stronger export growth in emerging markets," wrote UBS strategist Bhanu Baweja, adding that was a precondition to achieving better earnings growth as well as improvements in regional current account balances.

That leaves most Asian markets well below their highs for the year, struck in May. Indonesia's rupiah is 14 percent weaker than its May high, while the Philippine stock market (.PSI) is about 12 percent below the May peak.

Part of the reason why the rally petered out is justifiably owing to the Fed. Markets surged after September 18, when the Fed held back from cutting its massive asset purchase program, but investors know it's only a matter of time, and data, before five years of easy U.S. monetary policy is wound back.

Fed funds futures have adjusted to price in a delayed and slower pace of policy tightening, but the tightening is coming and bond prices would have to factor that in, said Sameer Goel, head of rates and currency research at Deutsche Bank.

"We are still looking at a process of repricing in the cost of money globally," Goel said.

That would warrant some amount of a risk-premium being built into financial assets, but the risk premium currently priced into Asian markets speaks of other concerns.

"Sustained emerging market currency gains require some form of fundamental grounding; hopes related to future global liquidity will not be - and have not been - enough," analysts at Morgan Stanley wrote in a note to clients.

WHERE'S THE GROWTH?

The fundamental underpinnings for a sustained rally in Asian markets have been sparse.

Leading indicators, the main ones being purchasing managers indices for each country, rose into expansionary territory in the third quarter.

But export growth has been disappointing in a region where trade drives much of the economic output and where a lot of optimistic earnings estimates are pinned on a U.S. recovery boosting demand for the region's tech products and cars.

That has set equity investors up for disappointment. Earnings estimates have stayed flat in most countries and sectors, barring sectors such as technology and financials and countries such as India. But expectations have run ahead, resulting in a 14 percent rise in the average price-earnings ratio for Asia ex-Japan since June.

The average PE ratio based on the next 12 months' earnings is 12.1 while consensus forecasts are for 2013 earnings to be up 8.2 percent, according to Thomson Reuters IBES.

Investors could lose patience if earnings fail to live up to what's been priced in, and gains this year are modest. Malaysian stocks (.KLSE) are up 7 percent, Indonesia (.JKSE) 2 percent and South Korea (.KS11) 2 percent.

UBS' Baweja said he was still long Asian equities, longer-tenor bonds and even currencies, but would be looking to cut those.

"Our base case is big change in emerging market macro isn't forthcoming, and with this in mind we are closer to closing out long risk positions than we are to adding new ones."

WHERE'S THE VALUE?

The dwindling opportunity to make money in Asian currencies is another big factor keeping investors, even those seeking just relative value trades, on the sidelines.

Expected measures of volatility remain elevated, particularly relative to developed market currencies. Implied volatility in the rupiah priced into 3-month options is above 9 percent, 3 times the level in May.

Three-month volatility on the Indian rupee is at 10 percent, double the levels in May and despite foreign investors turning bullish on Indian markets after the central bank's efforts to stabilize the rupee.

Forward markets on these currencies have meanwhile collapsed, eroding gains for those looking to exploit the yields in those curves. Indonesian 3-month implied yields, derived from the currency forwards, are now around 11 percent, a third of levels in September.

Meanwhile, expectations of eventually tighter global rates are keeping local currency bonds from rising any further, putting investors in a classic equities versus bonds dilemma.

For instance, Indonesian 10-year bonds trade 250 basis points (bps) above where they were in May. In the case of the Philippines, the yield is 60 bps higher, South Korea's is 75 bps, while in India, it is 130 bps wider than in May.

"The uncomfortable implication is that we will need to see global growth worsen in 2014 if yields are going to go significantly lower in the longer term," Claudio Piron, Asian head of strategy at BofA Merrill Lynch said.

(Additional reporting by Umesh Desai and Vikram Subhedar; Editing by Kim Coghill)