Sour cocktail drives investors away

Asia’s mix of cooling expansion, inflation, falling profitability and currency weakness appears to be deterring all but the bravest investors, which has resulted in a battering for share prices.

The Asian stockmarket has performed poorly so far in 2008, sliding about 26%. A fall of such magnitude inevitably tempts bargain hunters, but slowing economic growth and political instability seem likely to repel all but the bravest investors.

Much of Asia also continues to fight high inflation, which was pushed up by sharp increases in energy, raw material and food costs. Some central banks have resorted to interest rate rises in recent weeks to try to tackle the problem.

Inflation has stoked costs for businesses, while slowing growth has curbed demand, including demand for exports. As a result, corporate profits are falling. This mix of cooling economic expansion, inflation, falling profitability and, in some countries, political turmoil has pummelled share prices.

Rob Subbaraman, an economist at Lehman Brothers, says: “We expect Asian gross domestic product growth (GDP) to fall sharply this quarter and next as the export downturn spills over to domestic economies and exposes severe overcapacity in China. High inflation is sapping real household income and eroding profit margins, while the negative wealth effects of falling asset prices will hurt balance sheets and confidence.”

Economic growth in the Asian region excluding Japan fell from an annual 8.6% in the first quarter to 7.7% in the second, says Subbaraman, adding that forward-looking indicators and export volumes had started to flag.

The stockmarkets in India, China and South Korea were the worst performers up to September 5. The Indian bourse tumbled 40%, while the South Korean and Chinese markets fell about 37%.

India is trying to rein in inflation running at an annual rate of more than 12%, which has stoked fears that interest rates will stay high for some time, making investors jittery.

In China, the closely-watched Shanghai Composite index of domestic stocks crashed almost 65% between its peak in October 2007 and September 5. Investors hoping for a stockmarket boost from the hosting of the Olympic Games in Beijing were left disappointed. Slowing economic growth remains the key concern weighing on the Shanghai market. China’s economy expanded at an annual rate of 10.1% in the second quarter, compared with 11.9% over the whole of 2007.

Rumours that China will soon unveil a substantial economic stimulus package continue to circulate, but so far Beijing has not announced any such package.

“China’s three engines of spectacular growth are losing steam,” says Tu Packard, an economist at Moody’s “Industrial production growth is slowing, exports have decelerated and the investment cycle has peaked. GDP growth is forecast to fall sharply to 9.5% this year.”

Packard also expects economic growth in India to slow sharply “as tight monetary policy weighs on consumer and business demand”.

Morgan Stanley, the investment bank, said in a recent research note that there was a “risk of a growth scare in China” following the Olympics. “However modest this economic slowdown turns out to be, it is likely that investor discomfort might become rather acute, with meaningful implications for the region,” he said. “This will add to our bearish attitude towards the Asia ex Japan currencies.”

The bank expects the dollar to rally against most currencies in the region over the months ahead.

Currency weakness has already emerged as the major problem for South Korea, the third-worst performing Asian stockmarket. The won has fallen some 17% so far this year, sparking talk of a “mini” financial crisis in the country that the International Monetary Fund (IMF) bailed out with $58 billion during the Asian financial meltdown in 1997.

Politicians in Seoul and the IMF have rejected such talk as ill-informed, since South Korea and other Asian countries have substantial foreign exchange reserves and are in better economic shape than in 1997. But investors remain nervous.

Falling commodity prices have taken the shine off currencies in resource-rich nations such as Australia and Indonesia. Thailand and Malaysia have also suffered, in part because of deepening domestic political instability.

The Thai capital, Bangkok, under a state of emergency at the time of writing, has been hit by street protests demanding the resignation of the prime minister, Samak Sundaravej. On September 9, a court ordered Samak to step down, deepening the uncertainty and making Thai assets even less attractive to risk-averse foreign investors.

In Malaysia, the opposition leader, Anwar Ibrahim, is trying to unseat the ruling coalition. He has been hit by charges of sodomy, which he says have been fabricated to derail his bid for power. His supporters have threatened street protests if he is jailed, a prospect that has curbed investor interest.

“There is little equity investors can do about Asian currency weakness,” says Eugene Yiu, the director of financial analysis at the Altruist Financial Group, a Hong Kong-based consultancy. He adds that Asian currencies at the moment are not “very attractive”, but suggests the recent strength of the dollar could be short-lived.

The dollar rallied after data showed the eurozone, Japanese and British economies to be on the verge of recession. In contrast, America continues to expand despite the impact of the subprime crisis and ensuing credit crunch.

However, investors have begun to reassess this relatively upbeat assessment of the American economy in the wake of Washington’s decision to bail out the mortgage finance giants Fannie Mae and Freddie Mac. The federal takeover initially ignited a worldwide stockmarket rally, but analysts began asking whether the move really showed that the American economy was in bad shape. That judgment could in time hit the dollar.

Angus Tulloch, manager of the First State Asia Pacific Leaders fund, remains “cautious on the short-term global prospects” and is “fearful of stagflation”, but he is “as convinced as ever that careful stock selection will prove rewarding in the long term”.