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Made in China

Global equity markets have endured painful and dramatic gyrations in recent weeks. At Barings, we had been expecting further failures in the US financial sector for some time and have long been cautious from a top-down perspective on Western financials.

We see no reason to alter this stance for the time being, given that it is far from clear whether the financial sector is heading into the storm or starting to come out the other side. With Western economies facing a sharp slowdown or a recession, we expect to maintain a cautious stance in relation to developed markets.

Looking East, the situation is very different. Despite the Asian equity markets’ painful correction, the outlook is much brighter. The latest economic releases show that growth in China remains robust. In August, exports increased by 21.1 per cent year on year, imports grew by 23.1 per cent and the trade surplus reached a record $28.7bn. The Economist Intelligence Unit forecasts real GDP growth of 9.8 and 9 per cent in 2008 and 2009.

The inflation picture is also improving. Having reached a near 12-year high of 8.7 per cent in February, inflation has been on a downward trend and in August fell for the fourth consecutive month to 4.9 per cent year on year. However, recently there have been signs, including falling car sales, that economic conditions may be softening.

It is true that Asia faces the headwind of slower growth in the West which is likely to have a negative impact on the export industry. However, investors should be mindful that the Chinese authorities have considerable flexibility to address any economic downturn. We recently saw the first interest rate cut in six years as the People’s Bank of China cut the benchmark one-year lending rate by 0.27 per cent and the bank reserve requirement by 1 per cent.

We are aware that periods of heightened volatility can generate worthwhile investment opportunities and that taking a longer- term perspective is crucial.

The reindustrialisation of China over the last two decades has been one of the most remarkable transformations of any economy in recent years. Even though the public symbol of this transformation, the Olympic Games, has passed, we expect China to continue to deliver robust economic growth into the medium to long term.

In the long run, we think that China’s equity market remains attractive, given that many companies enjoy robust earnings’ growth and strong balance sheets, but these are turbulent, febrile times for equity markets and we have positioned our portfolios accordingly.

Our strategy is to continue to focus on companies with attractive share price valuations and sufficient cash flow to fund growth in the future. We continue to emphasise domestically orientated areas, with a particular preference for the beneficiaries of strong infrastructure spending in China.

We have reduced exposure to certain highly rated material and consumer stocks which analysis suggests would be most vulnerable if the economic outlook deteriorates. We have also lowered exposure to exporters as demand from developed economies is slowing and currency appreciation has squeezed margins.

The sale proceeds have been used to build exposure to selected financials, notably those that have produced better than expected results and enjoy a relatively high level of earnings’ visibility, which should serve our portfolios well, given that market volatility could be prolonged as the credit crunch plays itself out.

Following the recent correction, we believe the valuation of China equities now largely reflects concern about the global economic outlook. The crisis in the West is bound to have some effect on growth in Asia but we expect the economies of Hong Kong and China to continue to grow, supported by strong domestic demand and continued infrastructure spending. There is a window of opportunity for investors prepared to take a medium to long-term view but they should be prepared for volatility in the short term.

William Fong is investment manager of the Baring China select fund at Baring Asset Management


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