Asia (Ex Japan): China's potential remains intact

2008 proved that even relatively strong economies, with trade and fiscal surpluses, are not immune to the kinds of global shocks which we witnessed over the latter half of 2008. As the western economic and financial crisis worsened, liquidity fled emerging markets, causing a massive sell-off in equities across Asian markets. Fundamentals such as valuations, earnings growth, economic strength and government policy were all forgotten in the impulsive rush for cash. Parallels were drawn with the Asian financial crisis of 1997, particularly in Hong Kong, where the Hang Seng Index fell in percentage terms as much as in 1997 and in Korea where commentators predicted imminent economic and currency collapse. However, Asia's economies are more robust than they were a decade ago; economies have been reformed, country reserves are strong and corporate balance sheets are showing more equity than debt.

The high inflation which plagued Asia for most of the year has begun to abate as commodity prices retreat from their record peaks, allowing governments the breathing space to relax monetary policies. Nevertheless, most crucial to the survival prospects of these economies, in a global recession, is the development of domestic growth - not export revenue - as the backbone of GDP. As such, we see the main growth drivers for Asia being domestic consumption and infrastructure spending. The exuberance of China's markets in 2007 may have disappeared but our long-term enthusiasm for China and its economic potential remains. The market fall has certainly been hard - the MSCI China Index has fallen by around 70% since its 2007 peak (a 60% fall in 2008 alone). That said, forward price earnings calculations at the end of October stood at 9.4x, two standard deviations below the historical mean, representing some attractive investment opportunities.

Chinese GDP growth is slowing but remains strong at a forecast 9.5% for 2008 and above 8% for 2009. Furthermore, net exports accounted for only 16% of the nominal GDP growth in 2007, suggesting a recession in the US or Europe might have less impact on growth forecasts than feared. Recently, the Chinese government announced various measures to stimulate the economy and relax its tight lending rules including a US$586 billion stimulus package. We still believe that infrastructure and domestic consumption in major Asian economies, such as China, is the right focus. Fixed asset investment rose 27% in the first three quarters, while state budget spending on infrastructure rose 38% through August alone. On the consumption side, retail sales growth is expected to top 10% next year, as consumers' high saving levels combine with China's policy of urbanisation.

Strait talking

The Taiwan story is another long-term theme, as the Taiwanese economy is expected to turn around over the next few years with improved cross-strait relationships. The KMT election victory in late March triggered significant buying interest.

However, few concrete measures have passed since then and the stock markets plummeted along with the correction in other regional markets. Nevertheless, we believe the Taiwanese economy and stock market will benefit from stronger ties with China in the medium to long term, while the technology sector will also benefit from increasing demand in Asia.

India was the least affected by the economic slowdown of the West and is at an early stage of its infrastructure and consumer spending cycle. However, its stock market suffered significantly from the withdrawal of foreign funds. We expect GDP growth to be around 7.9% in 2008 and 7% the next year, while lower inflation risk following weakening oil and other commodity prices should enable the Indian central bank to further cut interest rates.

Korea, which has a high level of foreign currency denominated-debt and high gearing levels among its financial institutions, was under massive selling pressure in October as investors worried about the solvency risk of the country. The won depreciated to an eight-year low, the current account deficit widened to an all-time record, and GDP growth dropped to a four-year low. Government intervention prevented a full economic collapse, as a record 75 basis point interest rate cut gave some liquidity relief, while a US$100 billion foreign currency debt guarantee boosted confidence. We believe a weak won will help the exporters at the expense of its Asian peers such as Japan.

The ASEAN economies of Malaysia and Indonesia are blessed with abundant natural resources such as coal, nickel, tin and palm oil. Although the global slowdown will result in falling commodity demand, we believe these countries will benefit from Asia's long-term growth story. The economies are mainly driven by domestic consumption with exports being a smaller component of GDP. In the near term, we remain cautious towards Malaysia and Thailand as the latter's political situation remains unclear.

The present market turmoil enables investors to choose high quality growth companies at very reasonable valuations. We remain focused on domestic themes such as infrastructure and domestic consumption. Weakness in exports will be compensated by improved domestic demand while infrastructure investments will play an important role in sustaining regional growth. We believe that after the heavy selling in September and October, there should be a gradual rally over the next few months. We will continue to search for stocks with sound business prospects, strong balance sheets and healthy cashflows.