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Eastern earnings

The East represents the best potential for economic growth, according to Chris Lees Head of the global equity group, Baring Asset Management.

The East offers potential for an earnings’ surprise in the years to come.

We believe the prospects for positive earnings surprise will be greatest in Asia over the next few years and have positioned our investment portfolios accordingly.

A strategic bias towards the faster-growing economies in the East and away from the developed West has been a feature of our asset allocation for some time now and is likely to remain so for as long as the investment trends we have identified continue to play out.

Our central expectation is for a period of moderate economic growth around the world, accompanied by modest monetary tightening in a number of the more developed markets.

Our portfolios are very much positioned to reflect this view, with a sector bias towards the Asian equity markets, including Japan, and away from Western equity markets, where the likelihood of earnings’ surprise is lower in spite of respectable predicted economic growth and where valuations are already more challenging.

The exceptions are the UK and Europe, where prompt action by the Bank of England to control inflation appears to have been successful and where there are early signs of industrial recovery respectively.

When it comes to the US, though, our pessimism has increased. Although we expect the pace of growth to be respectable next year, share price valuations are already quite high. After a number of successively strong quarters for corporate earnings, expectations were starting to get a little over optimistic and we have seen a number of companies failing to meet these targets in recent weeks.

Changing demographics and the industrialisation of China are helping the pace of economic growth in Asia to stay considerably faster than in the bigger Anglo-Saxon markets.
The process of wealth creation is producing a rapidly expanding middle class, with a taste for Western-style consumer goods and with levels of borrowing far below those seen in the US and UK.

This bodes well for Eastern retailers, financial services and property companies, while continued demand for basic materials from China as the infrastructure networks are dev- eloped should provide opportunities for well managed industrial companies able to export to the Chinese market.
We believe that Western capital goods companies with market share in Asia and successfully able to compete with local businesses there could also participate in the strong growth we are anticipating.

By the same measure though, we also believe that the prospects for positive earnings surprise in many areas of the developed Western markets are diminishing.

For one thing, the pace of economic growth in the US, the UK and in Continental Europe is likely to be slower than in Asia. It should still be positive in absolute terms but the economy will not be expanding at the same rate and the opportunities for companies to beat consensus expectations will be harder to find.

For another thing, we find it hard to believe that the US consumer will continue to spend and accumulate personal debt at the same rate over this period. Levels of credit card debt are very high in the US and, as short-term interest rates rise over the coming months, we believe the savings cycle will turn and consumers will begin the long process of de-leveraging their personal balance sheets.
Clearly, this has to be very bad news for consumer goods companies and for large parts of the financial sector too.
Signs that some industries are struggling to pass higher raw materials costs on to consumers in the West also tend to steer us away from traditionally defensive sectors such as consumer staples.

Another area where we are cautious on a longer term strategic view is the healthcare industry in the West. These companies are now so big that new drugs need to be phenomenally successful to make a meaningful difference to corporate earnings’ estimates – and the pipeline of new products does not look particularly exciting. With fat profit margins in the industry and a soaring Medicare bill in the US, we expect companies to come under pressure from the new administration after the election.

Individual companies can always stand out and our bias here within the US and elsewhere remains the same: favouring companies with strong management, attractive levels of free cashflow and where valuations are underpinned by a dividend. Even so, we believe the healthcare industry as a whole could well become the steel industry for the next decade – declining returns on capital and falling share prices.

Meanwhile, the prospects for the steel industry and for other materials companies are looking very much better then they were five years ago.

The industrialisation of China has generated tremendous demand for raw materials and has helped to push commodity prices higher.

After years of cost-cutting, the prospects for positive earnings’ surprise at many of these companies are excellent, and a bias towards some of the better managed companies within the sector is another feature of our sector strategy at the moment.

Our intention is to increase our conviction in the resource sector on any weakness rather then to reduce it. Indeed, the structural growth pattern in Asia is driving a benign pricing environment for all primary producers.

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