Asia funds fear inflation may mean sucker's rally

“We may not have seen the worst,” said Alistair Thompson, deputy head of Asia Pacific equities at First State Investments in Singapore.

“There are risks of stagflation (in the West). That is not a good economic environment to be going into. And indeed we haven't really yet seen how much the economy is going to be impacted by this credit freeze. There's still a lot of risks out there.”

Stagflation, which slammed Western economies in the 1970s, is a rare and unwelcome mix of rising prices at a time when growth is stagnant.

Thompson, who helps to manage about $27 billion, said the firm had taken a large position in gold producers like Newcrest Mining Ltd, as the yellow metal is traditionally seen as an inflation hedge.

It is also avoiding Australian banks, which it sees as more vulnerable to any renewed financial turmoil given their high ratio of loans to deposits.

After reaching a record high on November 1, MSCI's measure of Asia Pacific equities outside of Japan lost nearly a third of its value before reaching a 2008 low on March 18.

Since then, it has rebounded about 20%, encouraged by the US Federal Reserve's aggressive actions to prop up the financial system following the near failure of investment bank Bear Stearns.

Money managers said that while it appears the worst of the global financial panic may be past, Asian financial markets will have to grapple with a problem closer to home.

“What is more important, more fundamental and more dangerous is that inflation in Asia has now come to a point where it is becoming worrisome,” said Bratin Sanyal, head of Asian equity investments at ING Investment Management.

“There is every potential for this problem to get worse from here, not better.”

Data released this month showed inflation at multi-year highs of around 8% in regional giants India and China. And that was before China's worst earthquake in three decades stoked fears of further upward price pressure.

With food and fuel prices soaring, inflation also topped 8% in the Philippines and Indonesia warned of 9% inflation there. Even Japan, which suffered nearly a decade of deflation, last month reported inflation hit a decade-high.

“We clearly have an inflationary problem on our hands. And the various administrators in Asian countries are trying to contain inflation. During periods of inflation containment, it's going to be painful for financial markets,” said Anthony Muh, head of Asia Pacific for AT Asset Management, which manages about $1 billion.

Already this month, China has raised reserve requirements for banks and Indonesia hiked interest rates.

The Philippine central bank is also under pressure to tighten. But like many Asian central banks, it fears the impact of hiking rates or letting currencies appreciate would put even more pressure on exporters already hurt by stalling growth in the United States, Asia's biggest export market.

ING's Sanyal, who oversees about $4.3 billion, said for this reason he is largely avoiding manufacturers and favoring “stodgy” companies with secure cash flows like phone companies.

First State's Thompson said he was also looking to more conservative investments, like Singapore's Oversea-Chinese Banking Corp, and saw value in beaten up Taiwanese technology plays such as contract chip maker TSMC.

AT's Muh said his firm, which already holds TSMC, fellow Taiwanese tech play Hon Hai Precision Industry and Samsung Electronics Co Ltd, was also taking a closer look at the technology sector because it had underperformed in recent years, making upside surprises more likely.

Not all money managers fear Asian stocks will test new lows this year. Ronald Chan, chief investment officer, Asian equities for Fortis Investments, said that with systematic risk easing Asian shares were likely to hold some gains. But he said the coming months could be tricky.

“The housing market in the US has not really seen the bottom yet ... for the next couple of months you're in a period where you don't have earnings reports. People will then start focusing back on the economy,” he said.

The Hong Kong-based manager said he was wary of pricey Indian stocks, favoring cheaper markets like Malaysia and Taiwan.

Looking beyond 2008, fund managers were more bullish. First State's Thompson noted many of region's companies were in strong financial health. And the long-term structural factors that have fuelled the region's multiyear-bull run were seen as still in place.

These include stronger growth rates and higher growth potential than their developed market peers, the strong fiscal position of many Asia countries, and the emergence of a large and increasingly affluent middle class.

“There's a lot of cash sitting on the sidelines looking to reengage. So I think the market will at some point will start to move upwards quite sharply,” said AT's Muh. (Reuters)