Region looks to stay on right road

Capital spending is emerging as a strong driver of Asian growth, leading some experts to play down investor fears sparked by the American subprime crisis. But others see a worrying fork in the road.

The global uncertainty caused by problems linked to America’s housing sector has led to increased volatility in the Asia-Pacific stockmarket, but many regional indices have remained firmly in the black since the start of the year.

Some analysts and fund managers also argue that the outlook for long-term investors in Asia-Pacific may not be as bleak as the volatility might be taken to indicate, contending that economic growth is robust in the region, especially in booming China.

Adaline Ko, manager of the £51m Lloyd George Eastern Opportunities fund, says: “Prospects for equity performance in the Asian market remain strong over the longer term, despite the impact on short-term volatility arising from … angst in the US.

“Capital expenditure in particular is likely to become one of the major factors driving Asian growth over the next two to three years as major infrastructure projects roll out in China, India and other countries across the region. Valuations in most Asian countries are undemanding relative to growth prospects and … balance sheets are rock-solid.”

The recent share price volatility was apparent in the MSCI Asia Pacific index, which rose 14% between the start of 2007 and July 25 but over the next month tumbled to show a 3% loss. It subsequently recovered and was up 8.4% by September 14 compared with the start of January.

A similar pattern was seen in national indices, except that many of the bigger or higher-profile bourses show healthier gains this year. The MSCI China index, for instance, was up 47.5% by mid-September, double India’s return. The main Asian laggard was Japan, whose stockmarket fell 4% (see chart).

The summer falls were caused by problems in America stemming from mortgages extended to borrowers with poor credit histories. Some of the mortgages were sold on to American and international investors as securities.

Higher interest rates have led to a record level of defaults among subprime borrowers. This, together with stalled or falling house prices, has raised questions about the value of those mortgage-backed assets and has clouded the prospects for American economic growth amid a credit crunch as banks take fright. The uncertainty has unnerved investors.

For Asia-Pacific, the problem is less direct investment fund exposure to subprime assets than the possibility of the crisis causing the American economy to slow or even retrench, since Asia still depends on exports to America’s spendthrift consumers.

Another concern is that the subprime problem could lead to risk aversion and a flight of capital from Asia-Pacific stocks, which could hit the region’s economy.

Some forecasters are still reasonably upbeat about regional economic prospects. In a July update to its World Economic Outlook, published in April, the International Monetary Fund forecast more than 11.2% gross domestic product growth in China for 2007, and some 9% in India.

“The major upward revisions have been for emerging market and developing countries, with growth projections substantially marked up for China and India,” the IMF said in the update. Other analysts are less sanguine. Rob Subbaraman, an economist at Lehman Brothers, said Asian economies (excluding Japan) could be approaching a “fork in the road”.

In a research note he described three scenarios. The first sees a recovery in the stockmarket and no rate cuts by America’s Federal Reserve to shore up sentiment. The second, Lehman’s baseline view, envisages rate cuts in September and October, which restore investor confidence and financial stability despite an economic slowdown. The last scenario predicts more stockmarket falls and a deeper global economic slowdown despite cuts in borrowing costs.

“Scenarios one and two are bullish for the Asia ex-Japan economies,” Subbaraman says. “In scenario one, the region’s exports should stay strong and, as risk aversion subsides, net capital inflows should strengthen anew.

“In scenario two there could be some softening in Asian exports, but this should be more than offset by robust net capital inflows, attracted by the region’s widening interest rate differential and sound economic fundamentals.”

But the third scenario could leave Asia exposed, the economist warns, given that it relies on exports to America and to China, which itself often uses those goods in products sent on to America.

The fork in the road, Subbaraman explains, is between the second and third possibilities: economic overheating on the one hand, or a sharp slowdown on the other. “Whether or not the Fed cuts rates, the outlook for the global economy remains highly uncertain,” he says.

Aside from the broad economic trends, some specific investment opportunities caught investors’ eyes last month, including the possibility of a rally in the Hong Kong stockmarket as regulatory changes are set to open it up to retail investors on mainland China. This, said Malcolm Wood, a Morgan Stanley strategist, in a research note, “gives Hong Kong exclusive access to one of the world’s largest pools of saving.”

Mainlanders would commit $50 billion to $100 billion (£25 billion to £50 billion) to Hong Kong stocks initially, and then a similar amount annually, he predicted. Hong Kong’s Hang Seng index could become China’s third “potential bubble” after the mainland’s domestic and property share markets. “We see 20% relative upside for China-Hong Kong, and so far, we have seen about 6-11%.”

Strategists at Credit Suisse point out that China is not only allowing Chinese investors to buy Hong Kong stocks but that its central bank is to allocate up to $200 billion of its reserves to equity markets. “If just 5% of household deposits in China were to move into Hong Kong, which trades at a 55% discount to China, then that would equate to 19%” of the shares available in city, Credit Suisse says.