Asian assets the way to go

Published April 9, 2008

Asian assets the way to go

OVERVIEW

THERE are bright spots in markets, even if private banks are not calling an outright bottom yet. Astute picks in the credit space, for instance, could yield good returns. But as always, spreading your money into a few baskets is a prudent and even rewarding move. This is what the bankers think:

Genevieve Cua: What is your outlook for returns from global equities and fixed income this year, and for Asian and emerging equities in particular?

Ivan Leung: At the beginning of the year we were looking for single-digit global equity returns for 2008 and 'teen' returns for Asian and emerging markets. That was not a terribly exciting return target at the time. But from current levels, the upside is certainly attractive. Investors have the choice of buying now and holding on for the ride, or trying to figure out where the real bottom lies.

We recommend a mix of direct investments for deep-value markets and core positions, with structured notes that provide capital protection and good upside.

From here, fixed income is quite tricky. With interest rates at incredible lows, the remaining value is mostly in the credit space. And credit markets are particularly treacherous right now. We are gradually purchasing high-yield exposures and recently added mezzanine. These will be excellent long-term holdings after the crisis is resolved.

Stephen Corry: The current preference is for fixed income (high quality) over equities, although we are currently seeking a bottom in global equity markets to move our clients overweight. Back in late January we told clients to keep an eye on the 10-year US Treasury yield - a rising yield would indicate that the worst fears of a US recession were moving behind us and that better expectations lay ahead for economic and global equities. This has yet to materialise, while our US economist expects further declines in the yields of Treasuries.

But the recent collapse of Bear Stearns could mark a bottom in the S&P 500. Meanwhile we're telling clients to buy higher-yielding, high-quality fixed-income securities, select government agency, investment grade and preferred securities. All now enjoy sharply higher yields after indiscriminate selling.

Chew Soon Gek: We expect more volatility in the equity market, characterised by unusual spikes. Theoretically there would be setbacks and opportunities. This is typical of an end to a period of strong economic growth and market returns. US equity valuations are attractive on a risk-premium basis relative to bonds compared with over 20 years ago. Dividend yields are higher than two and five-year Treasury yields. But in a downward earnings cycle, stock prices tend to struggle to move higher.

On a 12-month horizon, the forecasts for equity markets are 10-16 per cent for the US, 8-13 per cent for Euroland, 6-10 per cent for the UK and 6-13 per cent for Japan. For Latin America and Asian equities, the forecasts are set higher at 10-17 per cent due to higher growth and earnings.

Norman Villamin: Our outlook for 2008 is cautious and we expect volatility to remain high. However, we do remain optimistic that equities will out-perform bonds this year. The first half of the year will be difficult but the outlook should improve in the second half. We are optimistic on emerging markets but very selective. We currently favour the value markets of Taiwan, Malaysia, Hong Kong and Korea in Asia and Mexico and Brazil in Latin America.

Roger Groebli: It will take several quarters, and some degree of anxiety will have to be overcome, before stimulating policies manage to offset the recessionary forces at work in the US. Our main scenario is that the US recovery will be delayed (forming a 'W' shape) and the Eurozone will slow moderately. But emerging countries will keep a healthy economic resilience.

Genevieve: What do you see as the major investment themes for the medium and long term?

Ivan: We believe Asian assets are among the most attractive. Given easy money, rising inflation, positive fundamentals and strong economic growth, we find Asian currencies particularly attractive. We expect they can even appreciate in an environment where the US dollar finally stabilises and eventually strengthens.

Regional stock markets are also excellent long-term investments. Positive catalyst value markets include Thailand and Taiwan. These markets have under-performed Asia ex-Japan for four years, but are in the beginning chapters of a positive domestic turnaround story.

Other deep-value markets such as Singapore and Korea are cheap but will likely require some patience. When export-leveraged economies are back in fashion - likely when the world is recovering in the second half of the year - these two markets should do well.

Stephen: Asia's infrastructure and urbanisation - migration from rural areas into the city. . . construction of roads and housing - will require heavy usage of materials and metals and is positive for these sectors.

On agriculture, soft commodity prices may be high currently but can go higher over the long term.

On distressed debt, the number of corporate defaults globally is forecast to rise sharply this year from multi- year record lows. This is a great environment for distressed debt specialists.

On unwinding leverage, some opportunities are occurring where there is forced selling due to margin calls or via fund redemptions.

Soon Gek: On Asian growth, we maintain that exposure to Asian and Middle Eastern consumers should remain one of the key components of a portfolio. Positives include sustained currency appreciation which favours the consumer, economic growth and rising incomes.

Asian clients should consider core portfolios with a significant weight in broad Asian, Chinese and Indian equities, specific infrastructure or private equity opportunities on an asset allocation basis.

On climate change, the key focus areas are the reduction in greenhouse emissions via cleaner technology, energy efficiency and environmental management.

On agri-business, the key drivers are population growth, rising income, limited arable land and global warming. This broadly covers everything from agricultural commodities to consumer products, seeds and fertiliser, among others.

Norman: On distressed assets, default rates are expected to rise as the US economy slows. Experience from previous cycles has shown that investments in distressed debt in these periods have performed well over the next few years after the economy recovers.

The main risk to this view is that the current credit market situation is unlike any we have come across before and it remains unclear if we have passed the inflexion point. But proper due diligence and manager selection can help mitigate this risk.

On emerging markets, Latin America and the Middle East present better opportunities than Asia. These markets tend not to receive attention from most investors and tend to be under-owned and overlooked.

On energy and infrastructure, global infrastructure spending will continue even in the current environment of uncertainty.

On agricultural commodities, this theme is very popular. We feel the upward momentum will continue as demand from bio-fuels and the emerging markets has added a new dimension. Tight supply globally also presents an attractive opportunity.

Roger: The current negative sentiment could at some stage also create investor interest, as it provides opportunities for entry points that will generate performance later in 2008, once the fog has lifted.

Investors will then wake up to innovation (alternative energy, water, climate change, agri-business), capex (large cap technology and industrial companies) and infrastructure themes again. Apart from themes, we favour surplus countries like the Middle East (GCC countries).

Genevieve: What are you currently advising clients in the light of sharp volatility and uncertainty.

Ivan: We entered the crisis by reducing our overweight in equities to neutral, and we continued to reduce and rotate risks by using capital protected structured notes rather than pure long equity. We further mitigated risk by using derivative collars that hedge on the downside but allow for a bit of upside participation.

We are opportunistically awaiting the time to aggressively put our excess cash back into the market. Some of the areas where we are overweight, besides cash, are commodities and alternative investments.

Stephen: Volatility typically marks a change in market leadership - the winners of the past five years may not necessarily be the winners of the next five years. And so we are telling clients to seek greater portfolio diversity. Emerging market equities, US small-caps and commodities have all enjoyed great runs in the past five years but it is prudent to seek exposure to new asset classes (for example, out of EM and into EU and Japan equities).

A particularly exciting development is how volatility increases the dispersion of stock and fixed-income returns. The return dispersion between the best and worst-performing stocks in the S&P 500, for example, is now at a cycle low. But higher volatility means that it is set to go higher this year. What's more the number of stocks that are outperforming fell to 45 per cent last year.

For investors, there is now less than a 50/50 chance of picking a winning stock. But with greater return dispersion ahead, those fund managers who can will do very well indeed. This plays favourably into the hands of long/short hedge fund managers with a strong track record in stock picking.

Soon Gek: Clients are advised to hold well-diversified portfolios calibrated to their return and risk level. Asset allocation is still key and private bankers should advise clients on the importance of diversification across various asset classes, geography, securities and currencies.

We maintain that a significant exposure to Asian assets is beneficial over the medium-term. Our proven track record, which dates back to 1989, is a clear indication that balanced accounts with bonds, equities, cash, and alternatives including commodities have held out well in market upturns and downturns.

Underlying assets should focus on quality. For the securities that fall within the asset allocation buckets, one should theoretically select companies with a sound business model, strong management and healthy cash flow.

We have also other absolute-return strategies that offer a cash-plus return. We expect outperformance of hedge funds against bonds and equities. We suggest that investors should consider allocating about 20 per cent of their portfolios in such low-risk funds of hedge funds.

We continue to recommend climate change, agri-business and infrastructure as thematic overlays to the traditional geographical allocation of stocks. These themes focus on longer- term trends that are less correlated to current business cycle considerations.

Norman: The current volatility in the markets only serves to highlight the importance of diversification and asset allocation. We currently recommend an overweight in global equities relative to global bonds and a neutral weighting to cash. Within global equities we are underweight US equities in favour of Europe and emerging markets, especially Latin America and Middle East.

Within Asian emerging markets, we focus on the themes of cash flow and yield and favour markets that are under-owned and where investors have moderated their expectations.

We are overweight on Korea and Taiwan. We find that Taiwanese shares are under-owned and we can find value beyond technology. In terms of sectors, we are overweight on telecoms, where we can find visibility, cash flow and yield, as well as banks, which trade cheaply on mid-cycle earnings and yield.

Genevieve: What about investments in view of rising inflation and a very weak US dollar?

Ivan: We have advised clients that we anticipate the USD to turnaround sometime later this year - most likely after the current crisis. Meanwhile, a safer way to play USD weakness is to invest in Asian currencies. Precious metals and commodities are also beneficiaries of USD weakness, although their investment rationale is not solely dependent on it.

Stephen: Emerging markets FX and commodities (gold in particular). Inflation-protected securities in the US (TIPs) imply very little inflation ahead in the US economy - we are less inclined to recommend these as the US undergoes asset deflation via declining house and equity prices.

Soon Gek: Opportunities include diversified inflation hedges via holdings of commodities, equities, treasury inflation-protected bonds, agriculture and livestock.

Precious metals like gold hold out well. Gold is an asset class playing its traditional role as a store of value, and acts as a hedge against financial distress and inflation. Low interest rates reduce the opportunity cost of holding gold which does not provide a yield.

Norman: During this period of rising inflation and a weak US dollar, we believe commodities provide an attractive opportunity as well as local Asian currencies, including the Singapore dollar. We expect regional central banks to seek currency strength to moderate the impact of inflationary pressures within their economy.

Roger: We expect downward pressure on commodity prices to continue in the short-term, especially if the USD is able to correct further (up). We advise our clients to invest into inflation-linked bonds and focus on high-quality bonds.

Macro concerns continue to pressure markets, as do potential earnings downgrades. At some stage, low valuations, and lower US interest rates and yields, will start to compensate. Emerging markets are expensive but display growth premiums. We favour high-quality, large caps with low valuation-to-growth ratios.

Our favoured sectors: energy, materials, healthcare and telecoms. We advise clients to seek diversified instruments for alternative energies, climate change, infrastructure and agri-business.

PARTICIPANTS

Moderator:

Genevieve Cua: Business Times personal finance editor.

Panellists:

Ivan Leung: JP Morgan Private Bank chief investment strategist.

Stephen Corry: Merrill Lynch Global Wealth Management investment strategist.

Chew Soon Gek: Deutsche Bank Private Wealth Management chief investment officer (Asia).

Norman Villamin: Citi Global Wealth Management head of research

Roger Groebli: ABN Amro Private Banking head of Asia equities.

KEY POINTS

# Overweight equities, which are expected to outperform bonds this year.

# Opportunities in higher yielding, good quality fixed income assets.

# Thematic picks: infrastructure, distressed assets, agriculture, selected Asian and emerging markets.

# USD may strengthen in second half; Asian currencies still hold upside potential.