>Asia Strategy Quarterly (MACQUARIE RESEARCH)

Green shoots or red herrings?

The global cycle is getting less worse
Accompanied by a turn in the second derivative of global economic activity and tentative signs of stabilisation in important leading indicators, Asia ex Japan has risen 28% from its recent trough on 2 March and is now up 39% from the late October low.

Valuations are still well below long-run averages
At 1.5x P/BV, 11.0x trailing earnings, 6.8x P/CF, Asia ex Japan is still well below long-run average levels on three of the four standard valuation metrics. On a forward PER basis, Asia ex Japan is currently trading on 14.4x, around half a standard deviation above its long-run average level of 13.1x. However, the uncertainty surrounding the ‘E, makes this measure only marginally better than useless at the current point in the cycle.

The 12-month risk/reward trade-off is attractive
With valuations still well below long-run average levels and key indicators of the cycle – such as the OECD leading indicator and our earnings revisions indicator for Asia ex Japan – moving higher, the 12-month risk/reward trade-off for Asian equities is undeniably attractive. If history is a guide, the odds of losing money are a mere 12%, while the odds of a greater than 10% return are 70%.

Upgrading Korea and Taiwan, tech and banks
Accordingly, it is time to selectively add beta to our model portfolio. Tech and banks stand out at the current juncture. These two sectors have underperformed in the rally so far; in the past they have been big outperformers when the OECD leading indicator is rising; and with valuations now only a touch above all-time lows, they command an overweight position, in our view.

We have also upgraded Korea, Taiwan and Singapore. With earnings expectations extremely low, Chinese institutional investor money on its way, and trading on a P/BV of 1.4x, Taiwan looks particularly attractive. Valuations are not as attractive in Korea, and its net-debtor status concerns us. But you are taking on history by being underweight Korea when the OECD leading indicator is rising and that is something we try to avoid doing. At 1.2x P/BV, Singapore is deep value and it looks like 1Q09 was the weakest point for growth.

Underweight China and Hong Kong
China has had a monopoly on good news flow in recent months and as a result is by far the most over-owned and over-loved market in the region. Moreover, from a bottom-up perspective, we are now struggling to find value. In addition to being cyclically challenged, Hong Kong is now plain and simply too expensive.

To see full report: ASIA STRATEGY