Asian equities still smart bet for investors

Serious Money: We have almost grown used to China's astounding growth in recent years. Its economy has managed to expand by an average of 9½ per cent over the past two decades.

Driven by capital investment, the country has enjoyed an astonishing period of rapid industrial production growth. Having become the workshop of the world, China's growth has been assisted by an explosion in exports.

For the past few years, there have been several forecasts of an imminent hard landing for China. Expectations of a sharp slowdown in growth, even of a recession, have been driven by a host of factors, not least of which have been concerns over the banking system.

One or two forecasters seem to believe that what goes up must come down: China's growth has defied expectations for so long, they must be due a bad run. Growth in 2005 has once again defied the gloom merchants, and because Chinese influence on the world economy and financial markets has grown in tandem, what happens next will be of crucial significance.

There are now several channels of Chinese influence on asset prices. The behaviour of the central bank has been an important driver of bond yields; global interest rates are lower than they would otherwise be thanks to the recycling of Chinese savings.

Cheap exports of manufactured goods, based on wage costs of less than €1 per hour, have kept inflation low. This has helped financial stability, reduced interest rates and boosted equities.

Of course, commodity prices have been boosted by voracious Chinese demand, not least for oil. China is now the world's largest consumer and importer of most industrial raw commodities.

Commentators such as David Hale, the chairman of Chinaonline.com, say that China has supplanted the US as the dominant market and price-setter for copper, iron ore, aluminium, platinum and other commodities. Hale says it accounts for over 20 per cent of global copper and aluminium demand - more than the US. China now produces 35 per cent of the world's coal, 20 per cent of zinc, 20 per cent of magnesium and 16 per cent of phosphate. It produces more steel than the US and Japan combined.

All of this commodity consumption has fed an industrial, export-led expansion. At some point, potentially quite soon, the next phase of China's development will mean that commodity demand will once again explode, with enormous implications.

This will occur if Chinese consumer spending begins to grow even faster than in recent years. If a new middle class starts to buy cars, appliances and houses, the raw material demands will mean that we have only just begun the era of super-high commodity prices.

It is surprising, perhaps, that with all this growth, Chinese equities have been such a lousy investment. The main equity indices are down 10-12 per cent for the year to date, for example. In fact, Chinese stocks have been in a volatile bear market since 2001.

There are many reasons for this, but it is clear that the way most investors play the Chinese market is anywhere but quoted Chinese stocks. Corporate governance issues form part of this picture, and the way to make money out of the China story is to start with a decision not to buy domestic stocks.

Smart investors have instead bought equities in other Asian markets, playing with the idea that Chinese growth is having a dramatic impact throughout the region. One of the reasons behind the rise of 30 per cent in Japanese equities this year is the boost to Japanese growth from China. Korea is up 43 per cent - there are lots of reasons for this, but one of them is China.

So, what happens next? There are still a fair number of doom merchants who think all of this supercharged growth will end in tears. While banking system fears have abated as financial reform has started, worries over the real estate bubble have grown. Serious Money is not pessimistic, but there are one or two hints - and they are only hints - that growth may be coming off the boil. That is a far cry from saying a slump is imminent, but if China does slow we will see all sorts of gloomy prognostications and extrapolations.

If, say, China slows from 9 per cent to 6 per cent, what will be more important: a fall of one-third in the growth rate, or the fact that the economy is still growing by more than almost any other major country?

Any slowdown on this scale - still a big "if" - will alarm markets and prompt fears over the much-forecast hard landing. Commodity prices could suffer and jitters about the knock-on effects on global growth will prompt equity markets around the world to take fright. The things that have done well out of Chinese growth will have a spell of underperformance.

All of this is conjecture, but China is bound to slow down one day, and we need to be ready for the consequences.

Provided it is only a relatively small-scale affair - and I don't think it will be more than this, at least for the next few years - the important fact to focus on will be the high growth rate. Market worries about a slump should prove unfounded.

Investors should keep their nerve and allow the traders to have their five minutes of fame.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.