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The China set

The Chinese effect is likely to spread out to other Asian equity markets during this year.

If 2006 was all about China, we believe 2007 is likely to be the year in which the China story spreads out to the rest of Asia.

We remain upbeat on the prospects for the Asian equity markets and believe investments in the region still offer plenty of sizzle in the run-up to the Chinese New Year celebrations and the Year of the Pig.

The strength of the Chinese equity market in 2006 has been widely reported. The Hong Kong Hang Seng index returned more than 30 per cent last year, while the Shanghai A Share index of locally listed companies rose by a remarkable 130 per cent in local currency terms.

The broader Asian markets benefited too, with the MSCI AC Asia ex Japan Index also returning 30 per cent in local currency terms. Yet, in spite of the strength of the Asian markets, share price valuations remain reasonable in our view, without hitting excessive levels.

We expect the global liquidity environment to remain supportive for the Asian equity markets in 2007 as the stability of earnings on offer begins to be more widely recognised by global investors.

Earnings’ expectations are likely to continue to be the major swing factor in Asian equity markets, with a wide differential in individual stock performance likely to favour an active bottom-up investment approach.

As the year progresses, our central expectation is that the strong domestic consumption and asset reflation themes in China will spread to the rest of the region, where momentum in the domestic economy has already started to pick up but where markets have continued to lag behind Hong Kong and China.

Within South-east Asia, we are favouring Indonesia and Thailand as likely beneficiaries of domestic demand growth stimulated by interest rate cuts. We have also become more positive on the prospects for the Philippines in the expectation that we will see some domestic reflation as a growing share of foreign income is repatriated.

In Malaysia, we have identified some interesting opportunities. The construction boom in the Middle East and the fiscal stimulus experienced in a number of Asian countries in recent months have been welcome developments for well managed construction companies and we have been adding to carefully selected Malaysian construction companies to benefit from this.

We have also been investing in selected Taiwanese companies in spite of a generally cautious view when it comes to technology stocks globally. We see limited upside on the more economically sensitive technology companies but have identified some companies which should perform well as a result of consolidation.

Some value is emerging in share prices in Korea but we continue to take a cautious view here. Share prices moved very strongly early in 2006 and, without an immediate catalyst, we expect to see little progress in Korea until later in 2007 when earnings’ visibility is likely to improve and we may look to increase our exposure.

The one cloud on the horizon for the Asian equity market has been the behaviour of US consumers and whether US interest rate rises are likely to prompt a slowdown in economic activity and a reduced appetite for goods manu-factured in Asia and exported to the US and Europe.

Our view continues to be that the underlying momentum in the US economy is so strong that weaker housing and automobile sales will have only a passing effect on economic activity. Unemployment is still at very low levels and the reduction in labour among housebuilders is being absorbed by the commercial construction sector. Other sectors of the economy, particularly anything energy-related, are booming. We do not expect US consumer spending to drop sharply and do not expect it to prove more than a modest headwind for Asian manufacturers in the months ahead.

The possibility of further interest rate rises in the US later in the year is something we will watching closely but our focus remains firmly on companies in China and South-east Asia which we believe have the potential to grow earnings against a very favourable macroeconomic backdrop.

Henry Chan is head of the Asian equity investment team at Baring Asset Management, London.

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