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Stay defensive in H2 2008 and focus on inflation themes


Credit Suisse’s Private Banking division adopts a cautious outlook for Asian equities in H2 2008 and expects the regional markets would stay in an extended bottoming process due to increased global uncertainty fuelled by the oil shock and policy tightening by global central banks. However, risk aversion, equity risk premium and valuations of the Asian markets are already near previous crisis levels, downside risk from current levels is expected to be limited. Credit Suisse favors markets with strong current account surpluses, healthy fiscal positions and low political risk. It overweights Taiwan, China and Singapore and underweights India and Korea. Taking into account the increased global uncertainties and inflation risk within the region, Credit Suisse recommends investors adopt a more defensive investment strategy to mitigate the downside risk. It also recommends investors reduce risk exposure by adding total return managed investment products to their core Asian equities portfolio to improve the risk-reward profile. For satellite investments, it advises investors to focus on selected inflation themes.

The oil shock has brought significant uncertainty to the global economic outlook and induced a major shift in global monetary policy. Ms Fan Cheuk Wan, Director and Head of Asia Pacific Research for the Private Banking division, commented, “We expect the Asian equity markets will likely stay in an extended bottoming process until a more sustainable market recovery can develop when oil prices start to correct more substantially later this year. With global risk appetite dipping near the panic zone again, we expect to see heightened volatility and erratic share price movements in an increasingly sentiment driven market in the coming months.” In contrast with the impact from the subprime crisis, the oil shock is expected to bring a more direct impact to the Asian economies due to the region’s dependence on imports of oil and commodities. Soaring oil and food prices underpin a greater threat to social stability in Asia than in developed economies, Ms Fan noted.

Risk aversion and valuations reach crisis levels
While Credit Suisse’s Private Banking division does not expect the Asian markets to see a sustained rebound in the near term under the macro uncertainties, it sees limited downside risk from the current levels, as key tactical indicators show that the correction is approaching a trough. Based on the 12-month forward P/E, the valuation of non-Japan Asia has corrected to 11.6x 2009E earnings, which is 15% below the 10-year average of 13.7x. Compared with the previous crisis valuations of 11x during the Asian financial crisis and 11.5x during the post-TMT crisis, a further correction to the previous trough P/E would imply a potential downside risk of less than 10% from the current level.

Inflation threat brings de-rating for non-Japan Asia
In deriving its revised 2008E year-end index targets for the Asian markets, it has assumed a de-rating in the P/E multiples for 2008 to reflect a rise in discount rate due to rising bond yields and higher interest rate expectations as well as a higher equity risk premium due to increased earnings uncertainties arising from profit margin contraction under rising energy and input costs.

“Based on our revised index targets, we estimate the Asia Pacific markets will deliver a market-weighted aggregate upside potential of 12% in the next six months and 22% in the next 12 months,” said Ms. Fan. “We highlight Taiwan, China (H-shares) and Singapore as the three most attractive markets because they are projected to deliver the largest upside potential to our 6-month and 12-month index targets. India and Korea appear to be the least attractive markets in the region, given their uninspiring upside potential to our 6-month and 12-month index targets.”

Within Asia Pacific, markets with strong current account surpluses, robust fiscal reserves and low political risk premium are favored, while it remains cautious about countries with trade deficits, weak fiscal positions and higher political risks. India, Korea and Indonesia are highlighted as more vulnerable to the inflation threat due to their weaker trade balances, while the outlook for Malaysia and Thailand has become more uncertain due to the political overhang.

Overweight Taiwan, China and Singapore
Credit Suisse’s Private Banking division upgraded its weighting on Taiwan from neutral to overweight due to: 1) positive outlook of its multi-year structural re-ratings; 2) positive domestic catalysts from the expansionary fiscal policy; and 3) the market’s attractive upside potential of 19.6% to the end-2008E TAIEX target of 9,000 and 32.9% upside to the mid-2009E target of 10,000, which equates to the largest upside potential among all the Asia Pacific markets covered by the company. The recent market correction offers excellent re-entry opportunities on Taiwan for long-term investors.

Under the negative sentiment impact of the collapse in the China A-share market and investor concerns about high inflation in China, the Hang Seng China Enterprises Index (HSCEI) corrected 26% in H1 2008, making it the second worst performing market after India in Asia Pacific. Credit Suisse’s Private Banking division remains positive on China’s growth outlook and believes China is well-positioned to weather the oil crisis. It does not expect high oil prices to have a major negative impact on the Chinese economic outlook due to its robust current account surplus, strong fiscal reserve and USD 1.8 trn foreign exchange reserve. China’s fast-growing foreign exchange reserve also offers strong support for further appreciation of the CNY to mitigate inflationary pressure.

Credit Suisse sees Singapore as a relative safe haven within the ASEAN region, thanks to its strong trade surplus and fiscal position. While inflation is expected to stay elevated due to rising electricity and gas tariffs and imported food prices, it expects it to peak sooner and at lower levels than in other Southeast Asian markets. We expect strong fixed investment growth over the next 18 months to provide a cushion against the headwinds from slowing external demand, although domestic demand could still soften with weaker exports growth in the coming months.

Japan is a tactical inflation trade
Credit Suisse’s Private Banking division highlights Japan as a tactical inflation trade, given the positive impact of a re-emergence of positive inflation on the equity market. Rising inflation has pushed real interest rates in Japan into negative territory, making deposits and bonds unattractive. This has driven an asset reallocation of Japanese institutions and households from cash and bonds into equities, leading to the recent correction in the JGB market. It sees further upside potential from the reallocation of global funds into Japan from the US and European equity markets, once foreign investors raise their Japan weighting from an aggressive underweight position in response to the deteriorating outlook for the USA and Europe. Japan is also expected to remain less vulnerable to high oil prices than other developed economies, thanks to its superior energy efficiency.

Investment themes for H2 2008
Add total return investments to improve risk-reward
“Taking into account the increased global uncertainties and inflation risk within the region, we advise investors to adopt a more defensive investment strategy to mitigate the downside risk when the Asian markets are searching for the ultimate bottom”, said Ms. Fan. Credit Suisse’s Private Banking division recommends investors reduce risk exposure by adding total return investment products to their core Asian equities portfolio in order to improve the risk-reward profile. Selected hedge funds are recommended due to their lower correlation with the broad markets and lower volatility of their returns.

Equities: Focus on inflation themes
(1) Agricultural and plantation plays - it remains bullish on agricultural and plantation plays, as they are expected to benefit from the global food crisis. It expects food price inflation to remain a key macro challenge for Asia in the coming quarters due to tight supply situation and renewed crop failures. Agricultural and plantation companies will gain from elevated food and soft commodity prices.

(2) Energy and mining counters - elevated oil prices and windfall gains of oil producers underpin the positive demand outlook for oil services and offshore and marine companies. Driven by high oil prices and strong demand for production units, order momentum for the offshore and marine sector is strengthening. The growth cycle for the sector is likely to extend beyond 2011.

(3) Japanese equities offer a tactical trade on inflation - Japanese equities are its recommended tactical trade to play the inflation theme. In particular, Japanese megabanks will benefit from the steepening yield curve and asset shift from cash and bonds to equities by Japanese institutions and households via investment trusts. It recommends telecom stocks in Japan due to their potential to raise dividend payouts with their strong cash flows and very low gearing. The commodity-related industries, including trading companies with an interest in mining and exploration, have seen a string of price hikes, which directly benefit profits.

(4) High-yield stocks offer downside protection - it favors high-yield stocks due to their strong cash flows, attractive cash dividend returns and high earnings visibility. Most of its favorite high-yield stocks are strong cashflow companies with a defensive earnings profile, including banks, telecom and REIT plays.

Foreign exchange: USD/EUR in range. Long SGD, CNY and TWD
Credit Suisse’s Private Banking division expects the Federal Reserve to put US interest rates on hold until Q4 2008 while the European Central Bank is forecast to have another 25 basis-point rate hike in the next three months. This is expected to put USD/EUR within the 1.50-1.60 trading range. For Asian currencies, the near-term prospects have become more uncertain, as it is unclear how long oil prices will stay at an elevated level and undermine the region’s inflation/growth outlook. It sees near-term risk for THB, PHP KRW and INR. But it highlights the currencies of countries where exchange rates are used as the main monetary policy tool to fight inflation as more attractive, including SGD, CNY and TWD.

Fixed income: Selected short-dated EM bonds
A new wave of credit problems is emerging, but to diversify the investment portfolio in an uncertain investment environment, selected high-quality short-dated Emerging Market bonds are recommended for their attractive yields.


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