>ASIA STRATEGY (MACQUARIE RESEARCH)

Blink and you miss it

Event
■ After two weeks marketing around Asia (during which Asian equities have rallied ~15%), we provide an update on our thoughts on Asian markets.

Impact
■ When thinking about the outlook for Asian equities, three key factors are important from a fundamental perspective:

⇒ Valuations. At 2.0x P/BV, 14.8x forward earnings and 20.1x trailing earnings, the odds of losing money on a three-month investment horizon are now 60%, while the odds of a greater than 10% return are a mere 16%, if history is a guide. To be long beta in the face of these odds, you have to believe that we are either about to see something special (in terms of economic growth), or ridiculous (in terms of market multiples). Both are possible; just not probable.

⇒ Direction of the global manufacturing cycle. When key indicators of the cycle are rising, returns on Asian equities are strong, and when they are falling, returns are negative (see first chart opposite). For equity investors in Asia, getting the direction of the cycle right is crucial. The two most reliable and timely indicators here are earnings revisions (for Asia ex Japan) and the US ISM (new orders minus inventories). Both are close to 20-year highs (see second chart opposite), suggesting the next major move in these indicators is much more likely to be down than up. And if the last 15 years are any guide, when these indicators are falling, it is
highly likely markets are as well.

⇒ Risk appetite. Risk spreads fell further in recent weeks as investors continued to chase high risk assets. Asian equities (a high-risk asset class) have been a key beneficiary of this trend. Forecasting changes in risk spreads is not our area of expertise, but if sentiment towards global economic growth now takes a breather as re-stocking demand fades (as we expect), risk spreads are unlikely to continue falling sharply, removing what is currently an important tailwind for Asian equities.

Outlook
■ With valuations stretched, and indicators of the global manufacturing cycle at near 20-year highs, the balance of risks to Asian equities is to the downside over the next three months, in our view. A pullback of 15–20% is our base case.

■ We recommend that investors have a defensive and domestic growth bias to their portfolios, with defensive sectors such as consumer staples and telcos as key overweights. In terms of countries, Singapore and Taiwan remain relatively good value.

■ The key near-term risk to our cautious stance is that strong liquidity flows continue to drive markets even further away from fair value. The more medium-term risk is an unexpectedly aggressive pick-up in final demand, which keeps indicators of the global manufacturing cycle elevated even as re-stocking demand inevitably fades.

To see full report: ASIA STRATEGY