Strong Gains Put Asia Stock Markets at Crossroads

Foreign investors have been snapping up Asian stocksfor the past four weeks in a row, with net buying totaling $12 billion – the best run since the first quarter of this year, according to global securities group Jefferies. But will the rally continue?

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It all depends on whether the world’s major central banks will provide markets with a monetary boost and on signs that China’s economic slowdown is finally bottoming out, equity strategists tell CNBC.

“Money has started to come back into Asian markets and two factors are now very important to the rally continuing,” said Herald Van Der Linde, Head of Equity Strategy Asia-Pacific at HSBC in Hong Kong.

“Central bank policies in the U.S. and Europe will be important and if we get more quantitative easing then more money should flow into Asian equities. We also need to see more signs that China is on a sustainable growth path as recent data have not been conclusive,” he said.

Data from China, the world’s second biggest economy, in the past few weeks have been weak. Numbers released on Monday, for instance, showed China’s industrial sector recorded a sharp 5.4 percent drop in profits in July from a year ago, quickening from a 1.7 percent fall in June.

“If in September, we see a pick-up in the China data and there is quantitative easing globally, that could set things up for a phenomenal rally for equities in the fourth quarter,” said Van Der Linde. “Right now, Asian markets are hanging in a balance.”

The MSCI Asia-Pacific Index, which has gained about 11 percent since early June, fell to a three-week low on Monday.

Equity markets globally have given up some of their recent gains as investors have scaled back their expectations for monetary stimulus in the U.S., partly on the back of comments from St Louis Fed President James Bullard, who said last week that current economic conditions in the U.S. were not bad enough to warrant more easing.

Kenneth Chan, Quantitative Strategist at Jefferies in Hong Kong, says there are positive signs for Asian markets.

“We see a rally in the market that is backed by long-term fund flows, which means the rally has the potential to be more sustainable,” said Chan.

“But it’s a bit too early to say we are going see a repeat of the first-quarter rally (when the MSCI rallied 12 percent). The inflows numbers remain solid, suggesting emerging markets are in a good position to outperform developed markets,” he added.

Investors bought a net $3 billion worth of Asian stocks in the week to August 22. They pulled out a net $1.8 billion from the U.S. stock market during the same week.

Within Asia, buying by foreign investors was strongest in Japan, with net buying totaling $1.2 billion, followed by South Korea, with net inflows worth $1 billion and Taiwan with $748 million in the week to August 22, according to Jefferies data.

Analysts said low valuations in these stock markets probably boosted investor interest.

“We are overweight Asia ex-Japan in terms of our equity market preferences,” said Richard Jerram, Chief Economist at Bank of Singapore. “This is partly because there is more resilience in the Asian economy than elsewhere and partly because the policy swing in China is likely to be favorable for the region.”

China is widely expected to boost its slowing economy through fiscal and monetary measures before the end of the year.

- By CNBC's Dhara Ranasinghe