Turbulent times make stock picks key, says HSBC

Please explain your methodology and its limitations in the current environment.
What makes forming a coherent equity strategy so difficult now, is that there are no reference points; historical relationships and normal cyclical patterns have been overwhelmed by recent events in the financial markets and their effects on real economies. But, in any case, it is important to realise that our asset allocation and equity strategy methodology is an art -- not a science. We don't simply put data into a quantitative model in order to produce an optimised result. Saying that, we do use a scorecard as a guide, that is, a seven-factor matrix, but its weightings and even the factors themselves are adjusted depending on circumstances. Currently, a greater emphasis is placed on countries which are willing and able to implement large fiscal and monetary stimulus packages, and where there is less risk to corporate earnings.

How do you see panning out for Asian stock markets this year?
We shall have to see during the next 12 months just how much the global economy picks up, and monitor the degree of financial risk that is still prevalent. But there will be times when markets will get excited by an improvement in cyclical indicators, such as export growth, or better sentiment indicators. The danger is that they will signal false dawns. Some data will simply look better because comparative numbers from earlier quarters have been so poor. There is also the unknowable, of course. We could get hit by sudden financial shocks. The net result for regional markets is a pretty volatile year's trading, with the MSCI Asia ex-Japan index ending the year plus or minus 10% (it is now down 2%).

How big a crisis is this for Asian markets?
Significant dangers include countries defaulting on their external debts -- particularly in Central and Eastern Europe but probably not in Asia -- and a rise in corporate bankruptcies and bond defaults. These could reach 10%-15% for subprime borrowers in the region. But, in general, Asian economies look in good shape. We're not experiencing a repeat of the 1997/ 98 financial crisis: there is no credit bubble and most banking systems have been operating prudently with comfortable loan-to-deposit ratios.

Which regional economy is most vulnerable?
Of the mainstream Asian economies, South Korea causes us most concern and domestic investors have perhaps been too complacent. Here, the banks' loan-to-deposit ratios are high at around 130%, there has been a big build up in household debt and the country's external debt is 170% of its foreign exchange reserves. But even Korea is unlikely to suffer the pain it endured during the crisis a decade ago.

And which will survive best?
China's likely resilience is by now a well-worked story. It has a comfortable fiscal position that can support massive infrastructure spending. And its banks, which saw a 70% increase in lending in January, have an average loan-to-deposit ratio of about 65%. In fact, the danger is that investors' expectations are too high. But, a country which has been largely over-looked is India. With exports making up only 14% of GDP and with its largest companies focused on the domestic economy, India is to some extent ring-fenced from many of the problems afflicting the world economy. Sure, it has a relatively weak fiscal position and is about to enter a turbulent political period with elections in April, but GPP growth should bottom at 6%-6.5% this year.

Following a top-down allocation process, sectors come next. Which do you prefer?
In a year when growth will be choppy, it doesn't make sense to make big sector calls. Instead, investors should look at the quality of companies. Last year, the classic defensives - utilities, food, telecoms -- that is, companies with stable earnings were preferred, but now even they are vulnerable to drops in earnings. For example, we saw that recently with Taiwanese telecom companies. We prefer cyclical companies that are likely to benefit from infrastructure spending -- civil engineers and cement makers for instance -- rather than consumer-oriented businesses, which are bound to suffer from a downturn in discretionary spending by people either made unemployed or afraid of losing their jobs.

So, stock selection is key?
Indeed. We like large-cap blue-chip stocks. And rather than focus on stock valuations, it is the quality of the companies that matter, so strong balance sheets, reliable cash flows and proven management are the key criteria. Of course, most of these companies look cheap on a valuation basis too. We have identified what we call "Asia's Super Ten", and our latest list is in our Asia Insights (February 6). These are: AU Optronics, ICBC, Infosys Technologies, Li & Fung, Reliance Industries, Shanghai Electric, Sinopec, Swire Pacific, Taiwan Semiconductors and ZTE Corp.