Asia Is in Prime Position To Keep Riding Recovery, But Not at Pace of 2009

By ALEX FRANGOS

Last year's rebound in Asian markets will be a tough act to follow, but that doesn't mean stocks can't continue to rise.

Asia outside of Japan led the world out of the global financial abyss in 2009, producing some of the biggest market gains of the year. The widely used MSCI AC Asia Ex-Japan Index rose 68.3% as confidence built that Asia's fastest-growing economies—especially China, India and Indonesia—were on more advanced recovery paths than their Western counterparts.

Few expect markets to repeat that kind of performance in 2010. After all, 2009 was a reaction to the market implosion of 2008. But 2009 confirmed that Asia, led by China with its large government reserves and broadly solvent banking system, avoided the leverage problems that ignited the crisis in the West and is in a better position to take advantage of the global rebound.

"Markets always slow in the second year of a recovery," says Markus Rosgen, Asia equity strategist for Citigroup in Hong Kong. But he expects gains in the range of 9% to 14%, based on the all-country Asia ex-Japan index, helped along by healthy earnings among Asian companies.

While 2009's performance sowed optimism among investors, new challenges could damp the party mood, namely fears of rising interest rates, inflation, capital outflows and asset bubbles. Mr. Rosgen warns a resurgence of the U.S. dollar has historically coincided with down years in Asian markets.

Meanwhile, Japan's markets continued to struggle. The broad Topix index was only up 5.6%, even as the Nikkei Stock Average of 225 companies finished 19% higher at 10546.44.

Japan suffered from a collapse in exports early in 2009, as the global financial crisis reduced demand, and then a strong yen made its goods less competitive abroad. Hopes that a new government would make structural economic changes faded soon after it took power, and concern about deflation mounted.

Japan's markets have suffered their second "lost decade" in a row. The Nikkei is 44.3% below where it stood at the end of 1999. It is 72.9% below its peak near the end of 1989.

Japan's loss seemed to be South Korea's gain in 2009. Korea benefited as its cheap currency versus the Japanese yen and the dollar allowed Korean car makers and electronics companies to win a bigger share of the export market. The benchmark Korea Composite Stock Price Index, or Kospi, rose 49.7%, its best year since 2005.

The best-performing Asian markets in 2009 were those that were most insulated from the world-wide collapse of trade. Indonesia's and India's domestically driven economies fall into that category. They also benefited from confidence-inspiring elections in 2009. Indonesian stocks rose 87% and India's Sensitive Index, or Sensex, rose 81%, but both countries face the risk of inflation in 2010.

What surprised many investors in 2009 was the ability of China, usually seen as an export-dependent economy, to quickly spur domestic demand. A giant government stimulus plan helped investment and consumption keep the economy humming.

China's stock market anticipated that spending gusher and powered out of the gates in early 2009 , avoiding hitting a new low even as markets in much of the rest of the world found their nadirs in early March. The benchmark Shanghai Composite Index hit its low point in October 2008. It rose 80% in 2009, but remains 45.7% below the October 2007 peak.

"It certainly surprised us how strong domestic conditions were to take some of that slack left by the collapse in exports," says Michael Lai, investment director for asset management firm GAM in Hong Kong. He thinks consumption will continue to be the backbone of the economy in 2010 and will drive consumer cyclical stocks in China.

Asia's head start in the recovery attracted a torrent of investment cash into the region. Asian investment funds outside Japan took in $25 billion in 2009, besting the previous record of $20 billion in 2007, according to data firm EPFR Global.

Those inflows boosted local currencies and made returns for holders of Asian stocks even greater in dollar terms. Currencies in South Korea, Japan, Thailand, Indonesia and Australia all posted strong increases against the dollar in 2009.

Hong Kong's and Singapore's stock markets, two of the region's most liquid, became major buying targets for overseas investors seeking to benefit from China's growth. The benchmark Hang Seng Index rose 52%, its biggest one-year leap in a decade, and Singapore's Straits Times Index climbed 64.5% to end at its highest close since Aug. 1, 2008.

The money inflows from outside the region, combined with China's 30% money supply growth, reinflated markets. But the upswing also caused policy makers to contemplate whether new and dangerous bubbles were forming in Asia, leading investors to expect interest-rate increases early in 2010.

Despite the gains in 2009, investors say market values aren't in bubble territory yet. Some believe that as corporate earnings expand during the recovery, stocks can continue to rise without valuations rising too high. Asian stocks trade around 2.1 times book value. During the market peak in 2007 that valuation measure hit 3 times, suggesting there still may be room to run.

Investors are betting Asia will expand healthily on the back of continued government stimulus and rapidly growing domestic consumption. Even modest growth in the U.S. and Europe, the usual source of demand for Asia's exports, would be enough to keep Asia's companies humming, said Sakthi Siva, emerging markets strategist for Credit Suisse in Singapore.

And should demand pick up in the West faster than expected, Asia could enter a period of supercharged growth. But that also would raise fears of inflation and put pressure on policy makers to hit the brakes.

Asian central banks already are contemplating removing the ultralow interest rates imposed during the depths of the financial crisis. But in the past, Asian policy makers have waited for the U.S. Federal Reserve to raise rates before acting themselves. The U.S. is a long way from raising rates and Asia is a step ahead in the economic cycle. Real-estate and food prices are already rising.

"Yields rising will cause investors to pause and question growth," says Adrian Mowat, Asia and emerging markets strategist for J.P. Morgan Chase. But rising rates won't necessarily snuff out the bull market. "Don't be afraid of higher interest rates if it's to remove the medicine" needed during the crisis, he says. "Worry about it if it's about inflation concerns."