Is now the time to invest in the ASEAN region?

Investors' obsession with China and Japan has meant many of us have overlooked the potential of the ASEAN region, the association of South East Asian nations, made up of Indonesia, Malaysia, the Philippines, Singapore, Thailand and now also Brunei, Bangladesh, Burma (Myanmar), Cambodia, Laos and Vietnam.

There are many reasons investors should take a closer look at the ASEAN region. It is made up of 600 million people, almost 9% of the global population. The population is young and increasingly well educated. Youth literacy rates are above 95% in all but Cambodia and Laos. Infrastructure spending is also transforming the region's potential, with $435bn spending planned by 2017. The ASEAN region is strategically well located, sandwiched between China, India, Japan and Australia.

Japan and other developed nations are struggling with their ageing and declining populations. China also has a significant demographic problem as its one child policy starts to take effect. The controversial policy has caused a decline in the working-age population and wages are rising quickly. ASEAN has slower wage growth, lower manufacturing costs and 65% of the young population is of a working age. As wages in China continue to rise you would expect to see more low cost manufacturing shift to ASEAN.

The region continues to attract ever more investment. In fact, foreign direct investment (FDI) in South East Asia’s largest economies was higher than in China last year. This was because Japan recently shifted a lot of their FDI away from China. Between 2010-12 Japan allocated roughly the same FDI to both ASEAN and China (12% each). In 2013 ASEAN's total share of FDI increased to 15%, while China’s fell to 7%.

This change is partly because of geo political tensions. Japan sees the ASEAN countries as a crucial counterweight to Chinese influence in the region and Prime Minister Shinzo Abe has been on a diplomatic charm offensive to bolster relations. In December, at the Japan - ASEAN summit (which excluded China), the two sides pledged to strengthen economic ties and expand security cooperation.

Just in the last few days, the first US-initiated US-ASEAN Defence Ministers’ forum took place highlighting the growing importance of ASEAN to the US. President Obama will visit a number of ASEAN countries on his Asian tour later this month. A lot of important players have a vested interest in seeing a strong and stable ASEAN. Trade between ASEAN and China itself has grown five fold over the last decade and it is expected to reach nearly $500bn this year. China is seeking to increase its FDI in the region five fold by 2020, although this may be threatened by ASEAN concern over China's growing strategic ambitions. Approved Chinese FDI in Vietnam jumped 710% last year.

2015 will mark a major landmark for ASEAN as the economic community comes into effect. This will eliminate tariffs and trade barriers, creating one of the largest single markets. It could prove to be an important catalyst for the region as it undergoes the next stage of its development. The Asian development bank (ADB) is sceptical that the targets for economic integration will be achieved in 2015. A number of sensitive trade issues, labour mobility and regulatory issues still need to be addressed. Nevertheless, as the region becomes increasingly more integrated this should benefit trade, growth and ultimately investors.

The ASEAN economy is already $2.3 trillion, which would make it the eighth largest economy in the world if it were a country and the third largest economy in Asia. However, when you consider that Italy has a nominal GDP of $2.148 trillion and a population of less than 60 million it highlights the potential opportunity. As the ASEAN middle classes grow, GDP is expected to rise considerably. The region may ultimately become a major economic and political power. Demographics will remain a powerful tailwind for the region for many years to come.

Valuations
GDP growth is no guarantee of stock market performance. All emerging markets have struggled since the US began tapering in the middle of 2013 and ASEAN countries have been no exception. Money has flown back to the US and bond yields in ASEAN countries have increased, particularly in Indonesia which has recently struggled with its current account deficit. The result has been a significant decline in the value of some currencies. The Indonesian rupiah fell further than the Yen in 2013. ASEAN markets fell back in the second half of last year and are not currently expensive by historical standards.

Risks
Whilst a growing and educated middle class is a positive, it can also lead to greater political unrest. There continues to be turbulence, particularly in Thailand and Indonesia, and this is likely to continue in the future. This disruption can cause markets to be volatile and it may deter further investment in the future. It is also impossible to predict what political outcomes will occur in the future, particularly in countries like Thailand where the political situation is a mess with many different factions vying for power.

There is also a risk that government policy missteps will have a negative impact on growth and markets. This was the case in Indonesia, where the government's subsidisation of fuel prices had a negative effect on the current account deficit. Subsequent attempts to use foreign reserves to strengthen its currency only made the situation worse.

The relative strength of the Chinese economy remains a risk for the entire region. Any fallout from China will inevitably impact the surrounding area, particularly those companies and countries which rely heavily on commodity exports. China also presents a geo-political risk as it continues to act with an aggressive expansionist foreign policy.

Funds
It is surprisingly difficult to gain exposure to the ASEAN region. If you own an Asia Pacific fund it may have some small exposure to Indonesia or Malaysia, but most funds are usually dominated by China, Hong Kong, South Korea, Australia and India.

The current lack of funds is almost in itself another reason to consider investing as the region obviously remains relatively undiscovered and certainly analysed by only a few. There is potential for a lot of new money to flow into the region as it becomes more mainstream, particularly if investors start to tire of China and look for opportunities elsewhere.

Conclusion

With its excellent demographics, tremendous potential and growing international importance, those investors willing to accept the risk and volatility could consider the ASEAN region. It may well continue to suffer, along with other emerging markets in the short term, but I believe it is an exciting investment opportunity in the, longer-term.

By James Yardley, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. James' views are his own and do not constitute financial advice.