Asian equity markets are likely to run out of steam after leading a one-month rally in global stocks, with the full brunt of the deep global recession yet to be fully felt on corporate earnings and balance sheets.

The 26 percent jump has been driven by cyclical plays such technology and consumer discretionary shares, mainly on hopes that the worst of the global economic recession was over and that China's growth was cranking up again.

But the road to recovery will be long. The global economy could take longer than expected to recover, banking systems may suffer fresh setbacks and credit markets are still strained.

Companies needing to refinance debt also continue to face steep costs in credit markets, even as their cash flow shrinks as consumer demand sputters.

There are a number of ways it can come a cropper. The risks are innumerable, said Tim Rocks, Asia equity strategist at Macquarie Securities in Hong Kong.

Analysts recommend look for companies with relatively robust balance sheets which may outperform their peers once doubts about a global recovery are finally wiped away, likely late this year or in 2010.

Other investors said they prefer to invest in high-grade bonds in the United States or elsewhere rather than Asian equities, thanks to the steep returns available due to a blow-out in credit spreads.

CHINA EFFECT

Markets more closely hitched to China's economic engine have benefited the most in the recent rally, as investors hope Beijing's nearly $600 billion of fiscal stimulus will filter through to regional economies, partly offsetting a collapse in exports to recession-hit Western markets.

Chinese stocks have climbed 32 percent this year.

Outside of China, Taiwan's TAIEX index and South Korea's KOSPI have been the next best performing markets in the world, gaining 24 and 17 percent respectively. Rush orders from China to bring technology to rural households has been a boon to companies such as Taiwan chip maker UMC.

Asia's relatively healthier fundamentals have been another factor behind the rally. While hurting from its extreme export dependency, Asia has avoided the crippled banks and high household debt levels plaguing the United States and Europe. Plus, Asian countries have hefty reserves.

Asia is in the beneficial position of actually being to afford stimulus without having to go into significant debt. That's a positive for the majority of Asian countries and a positive for production and growth going forward, said Al Clark, head of Asia-Pacific multi-asset investment at Schroders in Singapore, which manages $158.4 billion of assets.

Clark was among the investors preferring high-grade bonds.

PROFITS UNDER PRESSURE

Foreign portfolio managers are slowly reallocating funds to the region and away from safe-haven cash, but confidence remains fragile.

While analysts and portfolio managers believe the worst is over for Asian stocks after last year's 53 percent plunge, the worst in the 20-year history of the MSCI index, they warn the path to a sustained equity recovery will likely be a bumpy one.

Taiwan's export data, a leading indicator for the region, show the double-digit drop only slowing to 35.7 percent in March from a year earlier.

Also missing from the rally has been a strong improvement in credit markets, which usually tend to jump ahead of equities.

Even as the MSCI index of Asia-Pacific stocks outside Japan struck a six-month peak, the iTraxx index of AXJ investment-grade credit derivatives is near 330 basis points and has lagged equities.

Asian credit spreads are still so high. Liquidity that has been pumped into the system hasn't really filtered down as much as we would like to see in terms of people reducing credit risk, said Colin Ng, who oversees $410 million as head of Asia-Pacific equities at MFC Global Investment Management in Hong Kong.

The outlook for earnings and potential for severe cash flow erosion also remain big risks.

Company earnings growth is expected to fall 11.4 percent this year before recovering 23.3 percent next year.

Stock valuations are generally seen as attractive in Asia, but have already recovered from their lowest levels.

The 12-month forward price-to-earnings ratio (P/E) is 12.7 and falls to 9.4 for the year ending in 2011, according to data from I/B/E/S.

Until the slide accelerated last October, forward P/Es for the MSCI Asia Pacific index ex-Japan had not been in single digits on data going back to 2001.

The P/E ratio on Hong Kong's Hang Seng has improved to 12.25 from a low of 6.7 in October, compared with an average 15.0 over the past 13 years.

The surprisingly big gains in stocks, which have been accompanied by numerous reports citing green shoots in economic activity, have made waves across markets, pushing up bond yields and sparked a sharp steepening in interest rate swap curves.

In some cases the jump in yields and swap rates has caused an unwanted tightening of monetary conditions in some markets.

BALANCE SHEETS AND LEADING INDICATORS

Bank of America Merrill Lynch analysts said companies with low balance sheet leverage and larger market capitalizations looked attractive. Their recommendations include Singapore oil rig builder Sembcorp Marine and Taiwan's UMC.

But Rocks at Macquarie warned that falling revenue and a hefty burn through cash means some Asian companies could run into trouble if economies do not accelerate later this year.

After exports collapsed at the end of 2008, analysts are also keeping a close eye on how quickly companies burn off excess inventories and on any signs that restocking is taking place.

A combination of inventory restocking along with a turn up in leading indicators, such as the U.S. ISM report's gauge of new export orders and the OECD's leading indicator, may set the stage for a more pronounced rally, analysts said.

So far those gauges are not quite giving the green light: at 39 in March, the ISM export orders index was still the third worst on record -- only surpassed by the extremely depressed levels in January and February.

Equity analysts at Credit Suisse have an outperform rating on Asia outside Japan due to its economic flexibility, low financial and household leverage, lower commodity prices and undervalued currencies.

Credit Suisse said Asia tends to outperform 90 percent of the time when leading indicators turn up, and that seven of the nine leading indicators it tracks have done so.

(Editing by Kim Coghill)

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