>ALPHA STRATEGY: The bank for a changing world

■ We are raising China to Overweight and cutting India to Underweight.
■ China upgrade is based on our view of monetary policy easing ahead.
■ India downgrade reflects a market priced to perfection with earnings risk.
■ Downside risk to earnings is the biggest challenge facing markets in 2H10.

We have raised our recommendation in China to Overweight from Neutral and increased our target for the HSCEI index to 15,800. The key driver of our upgrade is our view that the next major change in monetary policy in China will be an easing. This view stems from the risk of a hard landing in the economy as the expected slowdown in domestic demand is joined by an unexpected slowdown in exports. A more dovish tone on inflation from policy makers has erased the risk of policy tightening that was expected and has paved the way for an eventual easing.

We have cut our recommendation for India to Underweight, from Overweight, reflecting our view that the positives have been priced in and there is a meaningful risk to earnings going forward. Our SENSEX forecast of 19,700 signals we still forecast the market will post positive returns over the next 12 months.

Taiwan is trimmed to neutral reflecting the significant earnings exposure of the market to Europe as well as the risk of margin squeeze from the hike in wages in China. Our sample of technology companies with significant China operations highlights the risk of a 32% drop in pre tax earnings based on the assumption of a 50% increase in labour costs.

The euro zone crisis and a short term peak in Asian GDP growth forecasts implies there is a material risk to earnings forecasts in 2H10. The correction in the market year to date has been driven by multiple contraction as opposed to earnings reductions. We anticipate that the next leg down for the market, which we estimate to be 9%, is likely to be driven by downward revisions to earnings. We view this is a mid cycle correction as opposed to trend reversal and forecast a 23% gain in MSCI Asia Ex Japan over the next 12 months.

To read the full report: ALPHA STRATEGY