Greg Kuhnert, manager of Investec Asset Management Asia Fund, believes that Asian investors have many reasons to celebrate.

First of all the scorecard. How did we do in 2006? Well we were both right and wrong regarding our Asian outlook in 2006. We were right about structural change in the region, which is leading to multiple growth drivers which will cushion growth in times of a global slowdown. However, we were surprised by the strength of Asian equity markets. We expected around 15% returns, while the market returned more than twice that. This was partly due to better than expected earnings growth, but also due to valuation multiple expansion as Asia’s numerous growth drivers unfold. While performance over the last three years has been stellar, we think Asian markets have further room to outperform global markets again, and here is why.

Let’s revisit the arguments for a re-rating of Asian equities. Asian growth is now more resilient to a global slowdown than previously. Global outsourcing continues, driven by cheap labour, and an educated and hardworking workforce. This has extended from cheap toys and accessories to higher value-added products like TV’s, computers, machinery as well as services such as IT consulting. Already major auto manufacturers are quietly stepping up sourcing of components from Taiwan, Korea and China. Many global banks have shifted their back offices and software development services to India. Asia is now an integrated part of the global supply chain of many large multinational
corporations. This trend will continue which should boost Asian growth even in the face of a global slowdown. And it’s not just about producing cheap goods to western designs. Asian companies are spending more and more on R&D and brand development to take a bigger slice of the profit cake. China is now the second biggest spender on R&D after the US, and its share is rising.

Meanwhile, local consumption is rising as income levels rise. This should cushion regional growth in the event of a global slowdown. This certainly was the case in 2005. The best example of how important Asia and emerging market consumption has become can be found by looking at global personal computer demand growth rates. Asia and emerging markets make up 45% of total global unit demand, versus 29% for North America, and grew by 18% versus only 2% for the latter.

If you exclude China, Asian investment has been in the doldrums since the crises. We see this as being a major growth driver over the next few years. Infrastructure is inadequate, unreliable and unable to cope with demand. Have you ever driven on the roads or used the airports in India and Indonesia? Capacity utilisation levels are high in factories and further investment is needed.
Fortunately, governments and companies have recognised this problem and investment is increasing.

The final reason why Asia should continue re-rating relates to macroeconomic stability. On average, inflation is below 3% and pressures are subsiding. Current accounts are generally in surplus while fiscal positions are in good shape and improving. Rating agencies are upgrading sovereign ratings. Currencies are still undervalued. Companies and governments are underleveraged from a debt perspective. This is completely opposite to the conditions that led to the 1998 crises.

Asian valuations are attractive. Asia trades at a 10% discount to developed markets on a PE basis but offers superior earnings growth prospects. Relative to its own history, on a PE basis, Asia trades in the lower half of its historic range. Liquidity into Asian equities is strong and improving. This is being driven by global and Asian investors. Global portfolio managers are underweight Asian equities, and we can expect this allocation to rise. Asian investors (the Chinese in particular) have historically held a large chunk of their wealth in bank deposits and bond funds. A rising stock market is boosting investor confidence and encouraging money out of these vehicles. This has been a key reason for the massive move in the Chinese market in 2006.

What are the risks? A recession in the US will spoil the Asian growth party. However, excluding the housing and auto sectors, which account for only 9% of the US economy, the rest of the economy is very healthy. A negative inflation surprise could lead to fears of the FED over tightening, but the evidence is pointing to the contrary.

In summary, the outlook for Asian equities looks favourable given robust earnings growth, room for multiple expansion due to cheap valuations and structural change. This will be further supported by a favourable liquidity environment.
So grab your invitation. In my view the Asian party looks likely to be the sort of long-term, all night, apologies to the neighbours affair to which all good investors dream of being invited.

Any information contained in this communication is believed to be reliable but no warranty is given to its accuracy or completeness. This communication is directed only at investment professionals and it should not be distributed to or relied on by individual investors. While opinions stated are honestly held, they are not guarantees and should not be relied on.