- Asian stocks have been undervalued on US economic strength vis a vis Asian tightening - The potential is there for a strong June quarter - QE2 uncertainty nevertheless throws up risks - Australia is a foreign proxy for Asia

By Greg Peel

Asian equities have been a popular destination for foreign investment flows post-GFC given the disparity between soaring emerging market GDP growth compared to struggling developed market growth. However late last year the tide began to turn as it became apparent the US economy would not double-dip but was indeed recovering quite strongly.

It all comes down to monetary policy of course. The Fed introduced QE2 to re-stimulate growth at the same time China was tightening its policy in order to rein in runaway growth. In the meantime there is still no chance of a US rate rise in the foreseeable future and the jump in oil prices on the MENA unrest has had Asian central banks accelerating tightening efforts in order to head off inflationary pressures.

Thus according to investment headlines, funds have been flowing out of Asian markets and back into US markets, evidenced by outperformance of the S&P 500. The risk premium required to hold Asian equities has expanded, note the analysts at Singapore-based DBS Bank.

Yet actual funds flow data do not support any hysterical headlines, DBS suggests. Flows to end-January were actually larger than a year earlier if not as high as the recent peak, and appear now to have stabilised. Beijing might be aggressively tightening, but that expectation has now been adequately priced in. DBS suggests Asian equities remain supported by the extent of domestic liquidity and on valuation terms.

Indeed, DBS suggests the lower level of foreign funds flow coupled with rising Asian currencies as central banks fight inflation has meant foreign investors have “missed out” on solid returns due to their caution.

DBS suggests three reasons why Asian equities could further provide strong returns in the June quarter. First is the extent of risk premium now being priced into Asian equities which DBS believes is sufficiently stretched, such that a rebound from risk aversion is due. Second is the potential for oil prices to soon retreat as the MENA unrest fear abates, thus alleviating concerns over the high oil price impact on Asian growth. Third is the scheduled June end for QE2.

It is QE2 which is most critical as far as DBS is concerned.

While an end in QE2 suggests a reduction in the supply of US dollars, DBS can still see further weakening of the dollar if the end of QE2 foretells an end to the strength of the US recovery. DBS expects the US economy to grow at a quarterly rate below 3% which is contrary to consensus forecasts above 3%. To get over 3%, retail sales and industrial indicators need to be higher than they are now, DBS suggests.

A weakening of the US recovery and a weakening of the dollar post-QE2 is positive for both Asian equities as an alternative and Asian currencies (foreigners gain on both share price appreciation and currency appreciation). And we can also throw in Congressional pressure on the Obama Administration to reduce the budget deficit as potential for the US recovery to slow.

On the flipside however, if the end in QE2 results in a big jump in US bond yields (ten-year yield back to 4% plus) as Pimco's Bill Gross suggests then this will undermine the risk-weighted yields on Asian equity investment, DBS suggests. Greater returns will need to be offered if US Treasuries return to more attractive yields.

Could QE2 end without much of a reaction at all? DBS suggests it could if MENA unrest is still diverting attention. All global equities would have already pulled back. In theory, the Fed would only end QE2 if it thought the US economy was now recovering under its own steam, such that the private sector can take over the stimulus. But the Fed has already wagged its finger at the US government, hinting that there will not be any QE3 if the fiscal side of the problem is not swiftly addressed (ie budget deficit reduction). While not admitting it, no doubt Bernanke cannot disagree with Bill Gross that ongoing money printing is just a Ponzi scheme which must one day collapse if it is allowed to run on indefinitely.

DBS believes the MENA impact will prove to be only temporary, but acknowledges the risk that it may not. The end of QE2 offers opposing potential outcomes. So while Asian equities are offering value at present in DBS analysts' view, caution is suggested for investment in the June quarter.

Recall that the Australian market acts largely as a foreign proxy for Asian investment.

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