Philip Poole, global head of macro and investment strategy, and Bill Maldonado, chief investment officer Asia-Pacific, for HSBC Global Asset Management, gaze into their investment crystal ball ahead of the Chinese Year of the Dragon.

Philip Poole, global head
of macro and investment strategy, and Bill Maldonado, chief investment officer
Asia-Pacific, for HSBC Global Asset Management, gaze into their investment crystal ball ahead of the Chinese Year of the Dragon.

It’s striking how different perspectives can be depending on where you
live and the culture you hail from. Take the dragon, for a topical example. In European
folklore it’s a fire-breathing scaly beast, feared by the people for its
unpredictable destructive power. Conversely in Asian traditions it is associated
with wisdom, bravery and longevity; revered as a guardian and a source of good
fortune.

As we enter the Lunar New Year, investors would be forgiven for steeling
themselves against the threats a European-style dragon represents. Confidence,
which plunged in 2011 as Europe’s debt crisis escalated and US politicians
squabbled over deficit proposals, isn’t likely to recover any time soon. That
said, we believe investors in Asia should welcome the Year of the Dragon with a
sense of optimism. While we can’t promise that volatility is going to vanish,
we see opportunities ahead for those with the courage to diversify their
portfolios and to take some risks within a medium- or long-term strategy.

Busting the myths

The first step is to face the realities of 2012. The eurozone is already
in recession and may take several years to fix its problems. The US is
looking in better shape, but gross government debt is still rising and tensions
will remain high on Capitol Hill in the run-up to the presidential and
congressional elections. Growth in Asia is likely to slow too, primarily because
this region cannot entirely decouple itself from the rest of the world.

What some people seem to be forgetting though is that slower growth
doesn’t mean no growth. They may not break records, but the 8.6 per cent GDP expansion
we forecast for China this year, and the 7.5 per cent for India, are still well
into positive territory. Most Western economies would be delighted to come
close.

As they struggle to decipher the political and economic headlines, we
believe many equity investors are overlooking the tried-and-tested benefits of
valuation analysis. A glance at the MSCI Asia ex-Japan Index’s 15-year average shows
it’s now cheap by historical standards, even though we’re not living a re-run
of the 2008 financial crisis, the SARS epidemic or the dot.com bubble. Europe
is probably the main source of systemic risk today. Asian corporate
profitability hasn’t collapsed, and we don’t expect it to.

There’s a case to be made that investors have become excessively
pessimistic about the prospects for some of Asia’s leading economies. Given
that China’s CSI benchmark and India’s BSE fell by 23.7 per cent and 18.9 per cent respectively
last year, does it seem logical that the Eurostoxx should have dropped less or
that the S&P500 should have risen? We would argue that some profitable
Asian companies are now undervalued, and so their shares have potential to rise
over the medium to long term.

Eyes on emerging markets

The reason we said earlier that investors should be courageous is
because stocks perceived to be defensive have in many cases now lost their
allure. It stands to reason that if everyone buys into companies making tinned
soup then at some point those companies become overvalued. To strike the right
balance, therefore, we recommend investors take informed risks after studying
price-to-book and forward price-to-earnings data. Indeed, our analysis shows
that investors buying at a price-to-book of about 1.5 times – the current
average of the MSCI Asia ex-Japan – would have an 85 per cent probability of gains if
they hold qualifying stocks for a year.

With about $120 billion of emerging market assets under management,
we’re constantly seeking and testing new investment themes. At the moment, we’re
attracted to emerging market industrials, materials, financials and energy;
so-called cyclical sectors. Among the reasons we believe in these sectors is
that we’ve seen central banks in countries including China, Brazil, Indonesia
and Thailand cut interest rates (or reserve ratios) to stimulate growth as
concern about inflation recedes. Many such countries still have scope to ease
further and to fund development projects with bond sales, while in many Western
countries rates are already near zero and public debt is significant.

We expect growth in emerging markets will increasingly be driven by
domestic consumption and by urbanisation, meaning companies providing goods and
services aligned to these trends are likely to benefit. Not only will these be
companies selling directly to the end consumer or government, but those further
back in the supply chain, such as raw commodities producers.

In defence of bonds

Many of our arguments about attractive equity valuations equally apply
to corporate debt – both investment grade and high yield. Again, the flight to
safety last year that saw investors dump corporate credit in favour of
government risk has left the bonds of some profitable companies undervalued.
Learning from the recent credit crunch, many companies in Asia and beyond have
stockpiled cash, building their balance sheets as a preemptive defensive
measure. Should the eurozone crisis escalate and continental European banks
curb lending again, these companies will be far better equipped to fund
themselves from internal resources than they were in the dark days after Lehman
Brothers collapsed.

As Asia’s debt markets mature, new opportunities such as Dim Sum bonds
are emerging. Chinese companies will come to this market to tap international
investors, and companies from Europe and the US will come to build their credentials
with Asia’s investment community. Already we see credit quality rising as
greater choice enables investors to be more selective about the bonds they buy.

In summary, recognition of the challenges ahead doesn’t mean we should
cower like mediaeval villagers faced with a European-style dragon. Instead, we
should take our inspiration from the auspicious dragon of Asian mythology,
selecting our investments carefully in readiness for an eventual return to
market stability.