Nikkei's Rally May Continue but Beware Chinese Investments

This Story has been updated from March 10 with additional interviews and market data.

NEW YORK (The Street) -- As the Nikkei stumbles and concerns rise around Chinese growth, investors are questioning the rationale for Asian investment.

The region has represented rich pickings for investors recently.

Japan's Nikkei rocketed 52% last year, fueled by monetary and fiscal stimulus as Prime Minister Shinzo Abe attempted to revive the stagnant economy. Investors in select resource or consumer companies exposed to China on developed exchanges have also booked solid gains.

China's rise is nothing new: The nation is projected to contribute more than 13% to global economic growth by 2016, up from just 4% in 2001. By contrast, the U.S. is forecast to contribute 22.5% to global GDP in 2016 -- a slide of more than 10% since 2001. Meanwhile, the S&P derives more than 50% of its earnings from offshore - a significant proportion of these from Asia.

In the shorter term, China's transition to a more consumer-based economy may be rocky. There is little expectation it will reach a stated GDP growth target of 7.5% this year, while key manufacturing and export data is weakening. Concerns are also rising around expected government debt defaults. Meanwhile, the Shanghai Composite also continues to disappoint: the index has shed more than 11% over the past year and is viewed as a "casino" by many fund managers.

John Rutledge, New York-based chief investment strategist at Safanad, has one word for those considering direct investment in China: "Don't". In the absence of enforceable property rights and a sound legal system, he prefers investing in China-exposed companies on developed markets. In the past, this was represented by stocks such as BHP Billiton, Peabody  (BTU)and BHP; amid China's transition to a consumer-based society it may be captured through companies like Yum Brands (YUM). Rutledge also advocates owning Samsung (through an ETF, for example) noting most Chinese mobile communications is driven by Samsung equipment. He points to developed Asian nations which provide financing (Singapore and Hong Kong) or technology (South Korea, Japan and Taiwan) to China, as other ways to benefit from growth in the world's largest emerging economy. 

But there are two sources of risk for would-be investors: company risk and investors losing their nerve over the macroeconomic outlook for China. "The second is the most important source of risk," Rutledge says. "Investors are pulling money from emerging marklets that they borrowed cheaply to invest at higher rates (as U.S. stimulus is wound back)."

This dynamic causes BlackRock's global chief investment strategist Russ Koesterich to steer clear of China for the coming 6-9 months. He does not deny there is opportunity in individual companies, but is concerned about China's credit problems and potential defaults. 

Perpetual's head of investment market research, Matt Sherwood, claims a crucial point. "Importantly, problems in the loan quality of Chinese financial institutions will not spark a repeat of the 2008 collapse of Lehman Brothers," he said. Instead, Sherwood said potential defaults would impact regional activity through confidence and trade channels. As a result, Chinese-exposed investments with strong balance sheets and robust operating models were the best form of risk management, the strategist said.

Strategists are more optimistic on the outlook for Japanese equities via the Nikkei and Topix. 

Both Koesterich and Rutledge expect a continued rally in Japanese shares, despite their stumble for the year to date. They point to a single ongoing driver for its rise: Bank of Japan stimulus. 

"For this year, the relevant question (for shares) is what will the Bank of Japan do?" Koesterich says. He compares the situation to the US - where until recently, shares would rally even on poor economic data, as it meant greater probability of further stimulus.  He also notes that unlike the U.S., most gains in Japan last year were driven by earnings growth rather than multiple expansion. Koesterich views Japanese shares as reasonably priced. 

Rutledge is pessimistic on the prospect of structural economic reform in Japan. But he expects stimulus to result in greater demand, and predicts the yen will weaken again - further buoying shares. His firm Safanad has significant direct real estate investment in Japan.

Others are pessimistic. 

Sherwood says it would be dangerous to ignore the expected failure of structural reform in Japan. 
The Sydney-based strategist said Abenomics (a package of economic and fiscal reforms implemented since late 2012) failed to address structural flaws in the Japanese labor market and lack of efficiency in the economy. "This will mean investors may struggle to hold onto recent gains, once the deprecation of the yen and the expansion in sharemarket valuations cease," he said.

Sherwood noted the Japanese export market had not benefited from the 33% depreciation of the yen since late 2012, with the nation's trade and current account balance both recently moving to a deficit for the first time ever. "So the impact of Abenomics on Japan, has primarily been on the price of financial assets, rather than a boost to broader economic activity," Sherwood warned.

The bottom line? Longer-term opportunities in Asia remain, but stellar-short term gains - excepting perhaps Japan - are a thing of the past.

-- By Jane Searle 

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