>The Asian-US Asset Allocation Debate (DEUTSCHE BANK)

A spirited debate within the asset allocation community has broken out over whether Asian stocks (and EM more generally) can continue outperforming the US into 2010. This is an understandable line of enquiry given Asian economies are no longer growing in isolation, and EM equity markets have enjoyed record inflows this year (in contrast to the US). We provide a synthesis of our tactical views on this issue below:

1.) Asia is at an historically high beta to the US. Corporate Asia’s high and rising operational gearing, coupled with accelerating foreign investor interest, has driven Asia’s equity beta (vis-à-vis the US) from ~zero in the early 1990’s to 1.4x currently. But a high beta bites both ways – we expect Asia to outperform in a S&P500 bull market, and underperform in any material sell-off (there is after all, no free lunch). While these relationships should gradually evolve longer-term as Asia develops its own endogenous demand cycle and anchor institutional investor base, we are skeptical that either Asian stocks or foreign flows will shed their manic-depressive nature in 2010. Moreover if our US colleagues are right on the S&P500 and US policymakers succeed in engineering a lower $US as a reflation instrument, Asian risk assets should enjoy a cracking 1H-2010.

2.) Over the past 15 years, the only period where the US outperformed Asia in a bull market environment was in the late 1990’s when: i.) the US enjoyed a tech-led productivity boom and record FDI flows; ii.) the US fiscal position was strengthening; iii.) the $US was trend appreciating; and iv.) Asia, Russia and LatAm endured wrenching financial crises. We don’t anticipate a repeat confluence of events anytime soon.

3.) There are few grounds for overweighting the US against Asia just yet, based on RV arguments: i.) Asia is trading with a higher fwd DY, cheaper fwd P/B, and the same fwd P/E (lower PEG); ii.) AxJ cyclicals are trading at a large fwd discount to the US; iii.) The relative price level of AxJ vs. the S&P500 has only just returned back up to 1990 levels, and is half that in 1993; iv.) Both regions are 30% off their respective highs; v.) Perhaps most strikingly, Asian financials are trading at a small (fwd PE) discount to US financials vs. an average 16% premium since 1995, and a 70% premium in 2007. Given our long-held view that Asia will likely be gripped in a policyand- currency-induced mini-bubble over the next six months that will disproportionately favour asset reflation plays (see “2006/07 Redux – Asian Overshoot Ahead”, Oct 13), we’d expect Asian financials to again trade at a decent premium to the US in coming months, before conditions eventually turn problematic later next year (when risks around a double dip escalate).

To read the full report: INVESTOR LETTER