Asia ex Japan Portfolio Strategy - March 2012

7/31/2019 Asia ex Japan Portfolio Strategy - March 2012

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SALES CONTACTSGuy Stille Tel: +852.2217.2853 Email: [email protected]

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A X J P o r t

f o l i o Q u a r t e r

l y

E C O N O M I C S & S T R A T E G Y

Quam Financial Services Group34/F Gloucester Tower, The Landmark, 11 Pedder Street, Central, Hong Kong

Tel: +852.2847.2222 Website: www.quamsecurities.com

Q2 2012

The 400bps overweight on nancials and short commodities bet coming into Q1 paid off, asthe LTRO worked its mean reversion magic and even BHP accepts the looming structural shiftin the resource intensity of Chinas growth (although almost certainly still underestimating itssigni cance). For the rst time since 2008, the market is looking for the US rather thanemerging markets to drive marginal global growth momentum and even achieve escapevelocity from Fed intensive care.

That leaves US consumer spending providing the key fundamental impetus to sustainingthe risk asset rally. While trends in bank credit and housing are improving, a recent weakeningin real personal consumption expenditures and disposable income, partly on gasoline priceswhich are at their highest March level ever, suggest a softening of incoming macro data,which will trigger a material correction by mid Q2. The question then will be whether markets begin to anticipate further Fed action by June

Key Points

The model portfolio for Q1 published back in mid-December was a pro-cyclical and high betaone focused on north Asia, nancials and industrials, but with an underweight in resources/ materials in anticipation of the China xed investment slowdown continuing. In Q2, after theanticipated policy driven mean reversion rally, its wise to partly reverse those bets, and bring portfolio beta closer to neutral, as the macro surprise index rolls over in theUS, albeit nothing like as ominous as the similar loss of momentum a year ago at this stage.

While the implied S&P 500 equity risk premium at 5.5% remains historically attractive,its a good bet that US corporate margins are nally peaking at 10%, versus a trend

6% as unit labour costs rise/productivity peaks (and core PPI is running ahead of coreCPI, implying a margin squeeze). Last quarter was relatively poor for earnings growth; Apple and AIG generated 90% of S&P 500 earnings growth. Overall US pro t marginswill likely fall this year and Q1 on consensus expectations will see marginally negativeEPS growth , ending 8 quarters of growth

Policy easing in China should accelerate this quarter ; that will do little to change the profound structural shift in the countrys economic growth model now tfully beginning, but will excite the consensus into thinking that a policy driven xed asset slowdown is over.

After a disappointing budget likely to result in a new FY scal de cit approaching 6% of GDP and the lagged impact of the new oil spike, India could well see WPI accelerate again inQ2, and a renewed rupee slide to 50-55

The recent improvement in the net global upgrade/downgrade ratio has been led by Japan , but a sharp and sustained reversal in the yen should be a zero-sum game for S.Korean consumer goods/electronic exporters, who have had a windfall from Wonweakness versus the yen and repeated Japanese supply chain disruptions in 2011. By end Q2, these stocks should be seeing H2 downgrades as their competitive environment gets tougher

A tight retail inventory picture in the US offers scope for a restocking boost to the Asian supply chain , even if GDP growth softens to 2%.Shipping activity will offer a lead

I retain an overweight in domestic Chinese equities, as policy initiatives to drive are-rating of the market accumulate, via boosting both domestic and foreign institutional in ows as well as restoring retail con dence via an insider clampdown (and new trading

account openings are rebounding, although the turnover ratio remains depressed).


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AXJ Portfolio Quarterly Q2 2012Page 2 of 15

Source: Bloomberg, rst week of October = 100

Country Allocations Q2: Still Long China, Underweighting High Global Beta Markets/India Reversing Q1 Indonesia Underweight

Index (%) Weight Q2 (%) Divergence Q2 (bps)

China 23.6% 26.1% 250

Korea 21.0% 19.5% -150

Taiwan 15.3% 14.3% -100

HK 11.2% 10.7% -50

India 8.8% 7.8% -100

Singapore 6.9% 6.4% -50

Malaysia 4.5% 5.5% 100

Indonesia 3.8% 5.2% 150

Thailand 2.9% 2.9% 0

Philippines 1.1% 0.6% -50

China H-Share Bet Paid Off in Q1, While Resources Lagged...


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Sector Allocations: Reducing Beta and Financials Bet from Q1, Tech Exposed to AppleReversal, Despite US Restocking PotentialMaterials Short Closed on China Easing

Index (%) Our Weight (%) Divergence Q2 (bps)

Financials 30.0% 31.0% 100

Materials 7.5% 7.5% 0

IT 18.7% 16.7% -200

Industrials 9.9% 8.9% -100

Consumer Discretionary 9.8% 10.8% 100

Energy 7.8% 8.3% 50

Consumer Staples 5.2% 5.7% 50

Telecoms 6.3% 6.3% 0

Utilities 3.6% 3.6% 0

Health Care 0.8% 0.8% 0

Source: EPFR

Surge in YTD Regional Equity In ows Likely Peaking


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Source: Factset

Eurozone: Respite, not Reprieve from Solvency Risks At the end of 2011, the interbank market was completely dysfunctional in Europe, and we risked a de ationary spiral

triggered by forced euro zone bank deleveraging. The ECBs LTRO operations have added on a gross basis about 1trnto bank balance sheets over the last few months, and the interbank market has been normalising in terms of Euribor spreads if not liquidity. Aggressive buying of local debt by Spanish and Italian banks with 1% ECB funding helped bring10-year yields in both countries down by over 200bps from late December, fuelling the global risk rally, but Spainsbenchmark government bond yields rose above 5.5% for the rst time in two months last week on fears aboutthe countrys deteriorating de cit outlook and weak growth prospects.

Italys 10-year yields also moved back above 5.1%. Despite a robust German IFO survey, a mild recession, focusedin the periphery, remains on track. Eurozone March PMIs suggested weakening growth prospects even in coreEurope, with declines in both manufacturing and services. The composite index, covering manufacturing andservice industries, fell from 49.3 in February to 48.7 in March, the weakest for 3 months. Spain and Italy were bothnotably weak, and look like suffering a signi cant period of recession this year. The Spanish economy, the fourth-biggest in the euro zone, is set to enter its second recession since 2009 as austerity measures in three decadesdepress domestic demand.

Source: Bloomberg

Asian Staples Still Expensive, Despite Q1 Derating

Has LTRO Impact on Spanish/Italian Yields Peaked?


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The brinkmanship between the Greek government and bondholders ended with 85% of the debt in private-sector handstendered to the swap, which implies deeper losses than suffered by any private holders of Latin American debtin the 1980s . The oil spike means that there are heightened upside risks to in ation even as some downside risks to

growth (notably the tail risks associated with a banking crisis throughout Europe) appear much less likely following thesuccess of its LTRO and the Greek swap deal.

Source: Bloomberg

The ECB is taking a rmer tone with markets, as the LTRO has in its view had its desired effect in normalisinginterbank markets . ECB President Mario Draghi has retreated from his previously dovish stance, indicating theinstitution has done quite enough to soothe markets anxieties and so has no further easing in the pipeline. The ECBsrefocusing on medium-term price stability was underlined by the release of its revised in ation forecast of 2.4% for 2012, almost a half-percentage point above its December forecast of 2%. Any further ECB action depends on a markeddeterioration of the economic outlook

Source: Markit, Eurostat

The Spanish government has forced the savings banks to write down 50bn in their property portfolios this year butof cial estimates assume mild further price falls and a quick rebound in growth. The scal de cit was 8.5% of GDP

But Downtrend in Euribor Continues...

Composite PMI and Con dence Still Recessionary


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last year, a big overshoot, but the reason was not scal indiscipline. The recently-revised target is 5.3% for thisyear and 3% in 2013; in other words, the public sector is removing 5.5% of GDP over two years in the middleof a recession . Portugal and Spain remains stuck in a worsening debt trap, and default at least on its private sector

obligations will be the only escape. Spanish export growth slowed in January to 3.9% y/y, compared with 6.6% in December. The government predicts

a 4% fall in domestic demand in 2012. The same unsustainable structural growth/productivity/debt fault linesrisk shaking the recent calm in coming months, unless Germany takes a very unlikely step toward scal union andmutualises peripheral liabilities. The oil spike will exacerbate peripheral funding stresses while making the Germans(and ECB) nervous of in ation risks. Portugal, with a debt/GDP approaching 150% by mid-decade, will likely needa bailout later this year . Meanwhile, Spain always looked more a far more likely candidate than Italy to be the rstmajor euro zone economy to succumb to an unsustainable growth/debt trajectory, despite the bizarre anomaly of itsdebt yielding 200bps less than Italys back in January.

In Spain, the private sector debt level reached 230% of GDP at the end of 2010. The housing market saw prices fell11.2% last year, and 21.7% from the peak in the third quarter of 2007, but that represents only half the Irishadjustment for a broadly equivalent property bubble. In Spain, it would be reasonable to assume real priceswill eventually fall to where they were in the mid-to-late 1990s. Meantime, Greece remains hopelessly insolventand headed for either a third bailout or default within 12-18mths. Whether or not these issues become dominantthemes for global investors depends partly on the outcome of the forthcoming French election, with a win by the anti-austerity socialist candidate likely to alienate Germany, and create stalemate ahead of the German elections in2013.

US Positive Data Surprises Peaked in Q1, as Energy Drag Increases

Were likely to see unusual weather related US data distortions drop out in Q2; while utilities/transport demand(particularly rail) has been depressed by the unusually mild winter weather, on a net basis by bringing forward constructionand retail activity, it has boosted the underlying trend . US retail sales advanced 1.1% in February, after an upwardlyrevised gain of 0.6% in January . With household real incomes lagging, some of the growth in retail sales came onthe back of resumption in consumer credit growth. Retail sales measure the goods component of consumer spending(or about 35%). At its latest meeting, the Fed raised its assessment of the economic outlook, but acknowledged risks togrowth and signalled that it would keep its benchmark rate near-zero at least through till 2014. M2 and bank lendingto businesses continues to see improvement , the latter running at 15% y/y.

Higher oil prices constitute a redistribution of wealth and therefore demand from net importers to net exporters .Some of the initial income transfer is recycled into the purchase of assets of net importing economies as naturally, oilexporters obtain claims on net oil importers; an oil shock results in an asset market counterpart of the global wealthredistribution. The mini oil shock is a net negative for the global economy to the extent that it shrinks real ex-energyeconomic consumer spending and overall activity in the importing countries, while most of the windfall is hoardedby the oil exporters near term. In real, local currency terms, the 6-month trailing average price of oil for some

economies such as the US, China, and Japan has not yet reclaimed last years highs, while for others includingthe euro zone and India, it has exceeded them.

In fact, in the US the share of energy in total household expenditure has actually declined lately, courtesy of a mild winter (which reduced the volume of demand) and lower gas price quotes (which reduced the price of energy for some households). An oil price at US$150 per barrel would, depending on the demand responsiveness,add at least 0.7% of GDP to the barrel bill of oil importers. It would bring the share of GDP energy importers spend onoil to well above 4%, levels we havent seen since the early 1980s and would clearly be a risk off event.


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Source: Fed

The global wealth transfer from oil importers to oil exporters at current oil prices at around US$2.5 trillion for 2012,which represents 4.2% of oil importers GDP or 3.6% of global GDP. A further rise in oil prices to US$140-150 could

tip the more fragile parts of the global economy into recession, particularly if monetary policy accommodation iswithdrawn as a result; the ECB has recently been upgrading its 12mth in ation expectations, for instance.The latest Thomson-Reuters University of Michigan consumer sentiment report showed consumers think in ationwill rise to 4% in the next year, the highest expected rate since May 2011 when gasoline prices were also increasing.Meantime, t he March regional surveys done by the NY and Philadelphia Federal Reserve Banks showed far more manufacturers expect prices to rise over the next six months than those anticipating declines . The directimpact of a surge in energy prices is obvious, but the indirect impact via expectations and con dence is whatultimately undermines investment/consumer spending decisions.

QE3 Still Very Much on the Table

The window for further Fed action closes by June, given the election cycle. As the high frequency data likely deterioratesat the margin through April and May, QE3 will be rmly back on the markets agenda. The most likely form of that

action is open market purchases of mortgage-backed securities funded through the creation of reserves -Quantitative Easing 3 (QE3) - at the June meeting. We expect it to total around $500 billion to $700 billion to takeover from the expiration of the ongoing Operation Twist. An attractive alternative to the Fed would be to expandthe scale and scope of that existing program . It could stretch purchases out until the end of the year, implyingtotal new purchases of about $400 billion, and include MBS as well as Treasuries. Moreover, the Fed would usethe tools of monetary policy to sterilize the effects on the balance sheet; those tools include continuing to sell shorter-term Treasuries and arranging temporary reserve-draining operations. OT2 would allow the Fed to act sooner, say atthe March or April meeting, and frame the initiative as support for the ongoing economic expansion. It would also buysome insurance from criticism by keeping the overall size of the balance sheet unchanged.

Philly Fed Index Order Components Weaker in March, Con rming Softening in February PMI


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Source: Fed

Ben Bernankes academic work on the association between energy price spikes and subsequent recessionsputs part of the blame on the Feds historical response. As long as in ation expectations are well anchored, thestrong conclusion is that the central bank should ease policy to counter the blow to aggregate demand. Thus, therecent rise in oil prices and the risk that they go higher likely inclines the Fed to do more, not less. The Fed has signalledthat it doubts that a pick-up in in ation is a material risk to the outlook. The basic determinant of in ation in Fed-

style models is resource slack, which it still believes is considerable . After all, policy-makers have not raised their assessment of the natural rate of unemployment or lowered their estimate of the rate of growth of potential output. For good measure, the Feds in ation goal was raised slightly to 2%.

Source: BLS

US M2 and Lending Growth Still Trending Higher

Weak Income Growth Risk to Employment Recovery


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Gasoline prices shot up 6% in February to result in a 3.2% increase of the energy price index, despite a 3.4%drop in natural gas prices and a steady reading for electricity. Essentially, overall CPI is trending down but the impactof geopolitical risks in Iran is impacting forward consumer expectations of 1 year forward in ation, which have

surged to their highest level in a year; 5-yr/5-yr forward bond market implied in ation expectations have also jumped 30bps this month. The core CPI, which excludes food and energy, moved up 0.1% in February after a 0.2%increase in the prior month; on a y/y basis, core CPI moved down to 2.18% in February from 2.28% in January.

Over the past two months, despite positive high frequency data, consensus forecasts for Q1 US GDP growth havebeen inching lower, currently standing around 1.8%-2%. While Q4 2011 growth came in higher than expectedat 3%, inventory rebuilding contributed the largest share at 1.9 percentage points. Ive highlighted positive trends inUS housing since mid-2011, and they broadly continue. Requests by homebuilders for permits to build single-family homes and apartments exceeded expectations, rising 5% in Feb from Jan to 717,000 permits, hitting thehighest level since Oct 2008 and signalling that housing starts are likely to remain robust over the next few months.The median premium for new homes over previously-occupied homes currently stands at over 30%, or twice the levelin a typical healthy housing market. Starts in the multi-family sector (apartments) rose 21.1% to 241,000, the bestlevels since the crisis began in late 2008.

The June deadline for market intervention makes the June FOMC meeting the last practical date for a QE3announcement. If the Fed does embark upon some form of QE3, it will be, at least in part, to insure against negativeshocks through the election campaign in H2. Oil prices have risen by almost a third since their trough in October, andwhile markets have hitherto priced their impact on in ation as temporary (re ected by signi cant movement intwo year relative to ten-year in ation breakeven rates since the New Year), a recent shift in the dynamics of wageadjustments may change investors minds. A common argument is that a large output gap prevents even signi cantoil-price shocks from feeding through to the general price level, as workers cannot wrestle wage increases out of employers. The QE3 decision therefore comes down to whether the FOMC will accept core PCE in ation over 2% for an extended period to bring down the output gap. Id bet that they will, so long as the alibi of softer dataappears soon.

Source: US Commerce Dept.

US Retailers: Inventory Restocking in Q2?


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Source: Wind Information

China: Structural Growth Shift Underway or a Policy Driven Cyclical Slowdown?

Ive highlighted the unsustainability/implausibility of Chinas GDP trajectory many times over the last couple of years;about 62% of Chinas national income is now generated by state-owned enterprises while the pure private sector is probably no more than 25%, down from over 30% pre-crisis . There has been little meaningful rebalancingyet; Chinas household consumption growth still lags state directed investment. The World Bank issued a report atthe end of February which showed exactly the LT policy reforms which are desperately needed; the Chinesegovernment cosponsored it, so none of this is news in Beijing as regards the need to fundamentally rebalance growthdrivers, rational capital allocation and less resource intensive (and wasteful) incremental GDP etc. Is there the politicalwill among the senior leadership in China to tackle the huge vested interests who will be losers in a zero sum game thattransfers wealth to the household/SME sector?

Thats the key issue facing investors in coming months; if not, they will backslide on the current liquidity squeezeand give the economy another jolt of xed investment credit adrenaline, but at the cost of growing structuralinstability that will become impossible to control by mid-decade. Ultimately, lower but sustainable trend GDPgrowth driven by productivity gains from a better educated workforce using modern IT/business processes rather thanever more capital inputs is a positive scenario for investors; another throw of the stimulus dice, however relieved theshort-term reaction, most certainly isnt. Property sales value contracted 20% year on year in January/Februaryand volumes by 25%, the worst result since the series began in 2006. Prices fell in 45 of 70 cities in February

from January, according to prices released by the NBS. The average decline across the 70 cities is around 1.5% y/yon of cial data, and up to twice than on private estimates. Meantime, from what we know in terms of bottom up trends,if the of cial Q1 GDP print has an 8 in front of it, the tattered credibility of NBS data will be further eroded.

Asian Export Weakness Bottoming Out...
http://www.worldbank.org/en/news/2012/02/27/china-2030-executive-summaryhttp://www.worldbank.org/en/news/2012/02/27/china-2030-executive-summary


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Near term monetary easing will have to accelerate to provide suf cient credit to sustain even a 7.5-8% growthpath; another 150-200bps off the RRR by end Q2 is likely (although a differentiated strategy focused on second tier banks is very possible); meantime the RMB daily trading range will be widened substantially, and appreciation this year will be less than half last years at best. Liquidity in the interbank market does not seem to have translated into notablylooser nancial conditions for the corporate sector, because of binding constraints such as the loan-to-deposit ratio(especially on the big 5 banks), direct controls on loan drawdown and total deposits down YTD by about 1% at end

February. Japanese exports to China dropped 14% in February, driven mainly to a fall-off in machinery deliveries . An

improvement in Korean exports, which tend to lead Chinese exports, as well as solid US consumer demand creating apull through supply chain restocking effect in Q2. There is likely to be some boost to infrastructure investment growthrelated to environmental remediation projects in the near term, from the recent low levels of 4Q11.


Infrastructure Investment Still Sliding as Manufacturing Slows

Early Signs of Stabilization in Construction?


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Local governments need to boost their scal revenue resources from property-related sectors (especially land sales) tosupport ambitious plans for social housing as well as new investment projects under the 12th Five Year Plan. Any initialrelaxation of administrative restrictions on the housing market by mid-year will likely bene t rst-time property buyers,

while still constraining leveraged purchases of upgrade properties. Tangible evidence of reform to the hukoumigrant registration system and a successful social housing rollout will be helpful medium term, but policyrelaxation for property in top-tier cities and on mortgages for purchases of third and more units is not on theagenda this year.

The 2012 scal budget de cit target at around Rmb800 billion or about 1.5% of GDP, is lower than the budgeted 2% of GDP in 2011 (although on a cash basis, the actual scal de cit was Rmb519 billion in 2011, equivalent to 1.1% of GDP). The central government will likely expand the central de cit to increase nancial support for social housingprojects, as local governments remain cash strapped as land auction revenues dry up; units under construction willincrease to 13m units, with 5m units expected to be completed in 2012.


Structural tax reforms to boost household discretionary income are likely such as preferential tax treatmentsfor SMEs, personal tax cuts/subsidy programs etc. Budget priorities are social housing, agriculture infrastructure(e.g., water projects), urban transportation (e.g., subways), industrial upgrading, education and initiatives to boostconsumption - pension and health, etc. The PBoC has set M2 target growth at 14% in 2012, lower than the 16%target in 2011, but slightly higher than the actual growth of 13.6% at end-2011. The implicit new loans target shouldbe at least RMB8trn (versus RMB7.5trn in 2011), so the overall liquidity conditions will be more accommodative by H22012 than 2011. New credit will be much more targeted to avoid speculative leakage, with an emphasis onSME nancing, social housing, and selected infrastructure projects. The of cial release on government-drivenproject approvals implies that that infrastructure investment has now shifted more towards utilities and ruraldevelopment (such as irrigation/water conservation and rural infrastructure construction).

M2/Loan Growth Under Target as CPI Eases


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Are US Corporate Pro t margins Finally Peaking?

At the zero bound, not only are yields rendered impotent to elevate P/E ratios and lower real estate cap rates, but they begin to poison the nancial well. Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate pro t margins

and wreak havoc on historical business models connected to banking, money market funds and the pension industry . - Bill Gross, PIMCO March 2012 Letter

Bill Gross rightly identi es the unintended consequences of sustained zero interest rates as a key distortion in relativeasset prices but also a threat to corporate margins, despite the cash ow boost from record low funding costs. The ratioof corporate pro ts to wages remains at the highest on record since the series was started in 1947, and the bigissue for global investors remains if and when exactly this ratio begins mean reverting . The latest Fed Flow of Funds report included the preliminary estimates of Q4 2011 corporate pro ts and national income. The reports showed that national income increased slower than GDP, 2.9% in nominal terms versus 3.9% for GDP, or 1.8% and 2.8%respectively in real terms after adjusting for the 1.1% gain in the domestic demand de ator. The report also showedthat corporate pro ts had a q/q decline, though still up signi cantly compared to a year earlier . This decline inpro ts wasnt primarily the result of higher real hourly wages, though they rose slightly on the quarter whilefalling on the year, but of a rapid decline in productivity growth .

Real gain in national income was 1.8% in Q4, but aggregate hours worked rose 2.8%. That comparison is partlymisleading since national income includes the government sector while the hours worked number doesnt, but evenafter adjusting for that, were looking at roughly unchanged productivity, and a gain of less than 1% for the year.US productivity growth is stalling after a sharp cyclical upswing; unless the trend is reversed or real wagescontinues to fall, pro t margins will come under pressure. With the labour market strengthening at the margin, itwill be harder for rms to cut real wages much further. Thats an important in ection point

Despite the stronger job growth pace since Q4, only 58.6% of working-age Americans are employed today compared to63.3% ve years ago. Real average hourly earnings for all employees fell 1.1% between Feb 2011 and Feb 2012, whilereal disposable income decreased 0.1% in Jan from Dec. The prospects for further QE are subject to in ationarypressures in Q2, even though core in ation has been modest . Headline CPI increased as expected by 0.4% inFeb over Jan, and the largest monthly gain since Apr 2011. Over 80% of the uptick in CPI was accounted for by risinggasoline prices; the gure excluding food and energy was a more modest 0.1%. The price of retail gasoline averaged

Chinese Retail Investors Starting to Return


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$3.64/gallon in Feb, up from $3.44/gallon in Jan and a 15.9% increase y/y, and has touched $3.80 in recent weeks.Tensions in the Middle East continue to drive oil prices as sanctions on Iran tighten oil supply and the market attemptsto discount possible supply-side disruption in the Gulf. Meanwhile, the International Energy Agency expects worldwide

consumption of oil to grow 3.3% this year. The blended S&P earnings growth rate for Q4 2011 stands at 6.1%, but the estimated earnings growth rate for

Q1 is -0.5%. While the nal earnings growth rate for each quarter has nished above the estimated earnings growthrate at the end of each quarter during this streak, the amount of upside improvement in the growth rate has beensteadily declining. For Q4 2011, the increase was only 0.3 percentage points and just two companies accountedfor almost all of the earnings growth in the S&P 500 for the quarter overall: Apple and AIG. If these two companiesare excluded from the index, the Q4 2011 earnings growth rate for the S&P 500 drops from 6.1% to 1.2%. Comparisons to weak year-ago earnings are driving the unusually high dollar-level growth for AIG, while strong resultsin Q4 2011 are driving the high dollar-level growth for Apple.

India: Falling Short on Reform and Fiscal Discipline

India has failed to invest suf ciently in the infrastructure and industrial capacity needed to sustain recenteconomic growth levels, let alone accelerate them to Chinese trend levels. China, on the other hand, has relied oninfrastructure development to atter its growth and both countries are at crucial junctures. It has seldom been useful tocompare the two countries on a like for like basis because they are culturally and politically so different, but both needbold leadership this year to push through the reforms needed to evolve their growth models in opposite directions or risk a hard landing and turmoil by mid-decade.

I moved from a bearish stance on Indian equities from Q4 2010 to neutral at end Q3 2011, and have maintained thatsince with equity valuations having returned to trend but macro risks remaining elevated. None of the three highlyanticipated Indian events in March (state elections, credit policy and new budget) has given a further boost to Indianequity markets after a surge in the rst two months in portfolio in ows. Alongside the post LTRO spike in global riskappetite and ows, a relaxation of limits on purchasing Indian debt saw international investment in governmentand corporate debt surge to a record $31.5 billion in February , and Indian government bonds are Asias second-best performers this year after Indonesia. W ith no domestic macro impetus, it is unlikely that Indian equities canmaintain the outperformance versus its emerging market peers seen in Jan-Feb.

Credit policy, an anticipated fuel hike in April, the presidential election in June, and the monsoon forecast (with its keyimpact on food in ation, which has abated in recent months) will now emerge as the next prospective catalysts for themarket. In terms of the budget, scal crowding out raising the cost of capital for the private sector is a key issuein depressing desperately needed investment in India , as much as bureaucratic ineptitude and the byzantine landpurchase, planning and project approval system.

The plan to reduce the de cit to 5.1% of GDP in the next FY from 5.9% this is underwhelming, with consumer subsidies for fuel and food supposed to come down to 2% from 2.7% of GDP . The countrys trend non-acceleratingin ation growth rate is stuck at 6-6.5%, as the investment share of GDP risks sliding further below 30%, and yawningtwin de cits remain a source of on-going rupee volatility. Its not surprising that Indias corporate giants are now exportingcapital; p ost budget, bond yields rose, underscoring market scepticism of scal targets. On the balance of macro risks, India moves back to an underweight in Q2

Author:SEAN MAHER

Consultant StrategistQuam Securities

[email protected]: + 44.207.687 2213

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The projections and forecasts described in this report were based upon a number of estimates and assumptions and are inherently subject to signi cant uncertainties and contingencies. Projections andforecasts are necessarily speculative in nature, and it can be expected that one or more of the estimates on which the projections and forecasts were based will not materialize or will vary signi cantly fromactual results, and such variances will likely increase over time. All projections and forecasts described in this report have been prepared solely by the authors of this report independently of the Company.These projections and forecasts were not prepared with a view toward compliance with published guidelines or generally accented accounting principles. No independent accountants have expressed anopinion or any other form of assurance on these projections or forecasts.

You should not regard the inclusion of the projections and forecasts described herein as a representation or warranty by or on behalf of the Company, Quam/GAP, the authors of his report or any other personthat these projections or forecasts or their underlying assumptions will be achieved. For these reasons, you should only consider the projections and forecasts described in this report after carefully evaluatingall of the information in this report, including the assumptions underlying such projections and forecasts. The price and value of the investments referred to in this document/material and the income from themmay go down as well as up, and investors may realize losses on any investments. Past performance is not a guide for future performance. Future returns are not guaranteed and a loss of original capitalmay occur. Actual results may differ materially from those set forth in projections. Forward-looking statements are not predictions and may be subject to change without notice.

Quam does not provide tax advice to its clients, and all investors are strongly advised to consult regarding any potential investment. Quam/GAP and its af liates accept no liabilities for any loss or damageof any kind arising out of the use of this report. Foreign currency- denominated securities are subject to uctuations in exchange rates that could have an adverse effect on the value or price of or incomederived from the investment. In addition, investors in securities such as ADRs, the value of which are in uenced by foreign currencies effectively assume currency risk. Certain transactions including thoseinvolving futures, options, and other derivatives as well as non investment-grade securities give rise to substantial risk and are not suitable for all investors. Please ensure that you have read and understoodthe current risk disclosure documents before entering into any derivative transactions.

This report/document has been prepared by Quam/GAP, based upon information available to the public and sources, believed to be reliable. No representation or warranty, express or implied is madethat it is accurate or complete. Centrum has reviewed the report and, in so far as it includes current or historical information, it is believed to be reliable, although its accuracy and completeness cannotbe guaranteed. The opinions expressed in this document/material are subject to change without notice and have no obligation to tell you when opinions or information in this report change. This report or recommendations or information contained herein do/does not constitute or purport to constitute investment advice in publicly accessible media and should not be reproduced, transmitted or published bythe recipient. The report is for the use and consumption of the recipient only. This publication may not be distributed to the public used by the public media without the express written consent of Quam. Thisreport or any portion hereof may not be printed, sold or distributed without the written consent of Quam. Neither this document nor any copy of it may be taken or transmitted into the United States (to USpersons), Canada, or Japan or distributed, directly or indirectly, in the United States or Canada or distributed or redistributed in Japan or to any resident thereof. The distribution of this document in other

jurisdictions may be restricted by law, and persons into whose possession this document comes should inform themselves about, and observe, any such restrictions. Quam nor its directors, employees,agents or representatives shall be liable for any damages whether direct or indirect, incidental, special or consequential including lost revenue or lost pro ts that may arise from or in connection with theuse of the information.

This document does not constitute an offer or invitation to subscribe for or purchase or deal in any securities and neither this document nor anything contained herein shall form the basis of any contractor commitment whatsoever. This document is strictly con dential and is being furnished to you solely for your information, may not be distributed to the press or other media and may not be reproduced or redistributed to any other person. In particular, neither this document nor any copy thereof may be taken or transmitted into the United States, Canada or Japan or distributed, directly or indirectly, in theUnited States, Canada or Japan or to any US person.

The distribution of this report in other jurisdictions may be restricted by law and persons into whose possession this report comes should inform themselves about, and observe any such restrictions. Byaccepting this report, you agree to be bound by the fore going limitations. No representation is made that this report is accurate or complete. The opinions and projections expressed herein are entirely thoseof the author and are given as part of the normal research activity of Quam Securities Company Ltd and are given as of this date and are subject to change without notice. Any opinion estimate or projectionherein constitutes a view as of the date of this report and there can be no assurance that future results or events will be consistent with any such opinions, estimate or projection. This document has notbeen prepared by or in conjunction with or on behalf of or at the instigation of, or by arrangement with the company or any of its directors or any other person. Information in this document must not be reliedupon as having been authorized or approved by the company or its directors or any other person. Any opinions and projections contained herein are entirely those of the authors. None of the company or itsdirectors or any other person accepts any liability whatsoever for any loss arising from any use of this document or its contents or otherwise arising in connection therewith.

Important Information Regarding the Distribution of this Report in the United KingdomThis report has been produced Quam Securities Company Ltd and is being distributed in the United Kingdom (UK) by Seymour Pierce Limited (SPL). SPL is authorized and regulated in the UK by theFinancial Services Authority to carry out both corporate nance and investment services and is a member of the London Stock Exchange. Although Quam Securities Company Ltd is under separate owner-ship from SPL, Quam Securities Company Ltd has appointed SPL as its exclusive distributor of this research in the UK, and Quam Securities Company Ltd will be remunerated by SPL by way of a fee. This

report has not been approved for purposes of section 21 of the UKs Financial Services and Markets Act 2000, and accordingly is only provided in the UK for the use of persons to whom communicationscan be made without being so approved, as detailed in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005.

Quam Group is a founding member of Global Alliance Partners (GAP), an international network of local nancial institutions with of ces in 25 countries, a total of $40bn in AUM and which has completed $22bn in corporate nance transactions. GAP aims to leverage cross-border capabili-ties covering private equity, stock broking, research, fund management and investment banking. Other leading members include Reliance Capital (India), KT Zmico (Thailand), Seymour Pierce (UK) and Capital Partners (Japan).

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Asia ex Japan Portfolio Strategy - March 2012