Asian stocks have had a bumper year, but there is a widespread and growing consensus that it is time to exercise caution and reduce exposure.

The MSCI AC Asia ex Japan index rose 29.38% in the seven months to July 31, reflecting soaring equity markets across the region. India’s benchmark Nifty 50 hit a record high of 10,114 on August 1, while Malaysia, Hong Kong and Singapore stocks have reached two-year highs in the past two weeks. Meanwhile, South Korea’s Kospi closed above the 2,400 mark for the first time on July 14 and is still above that level.

One of the big drivers of this regional surge is that Asia is experiencing its first year of earnings recovery after six years of suppressed profit growth, according to a Goldman Sach report released in early July. The MSCI Asia ex-Japan index 12-month forward price-to-earnings ratio is estimated at 13.3x.

However, equity assets in the region now seem fully valued and it is difficult to see share prices rising further, said James Cheo, investment strategist at Bank of Singapore.

“There needs to be significant earnings improvement to push equity prices higher,” he told AsianInvestor. “From a portfolio context, we advise investors to be underweight Asian equities.”

Cheo believes markets will move sideways as they digest their gains so far. “With growth moderating and the increasing likelihood that US President Trump cannot enact big economic reforms, it is difficult to see much market upside,” he added.

Asset managers appear to agree. A survey of global mutual fund managers with AUM over $1 trillion remain around 520 basis points underweight Asia ex-Japan, according to the Goldman Sachs report.

Indeed, flows into emerging Asian equities have been very strong this year, but flattened out in June as economic numbers stopped surprising to the upside, according to a Bank of America Merrill Lynch note published on July 19 (see graph below).

Emerging Asia equity inflows (click to enlarge)

Jack Siu, Asia-Pacific investment strategist at Credit Suisse, was another to be urging caution on Asia equities.

While recent economic data in the region has surprised positively, growth momentum is expected to soften in the second half of the year, given the weakness in commodity prices and the “high base effect” of previously strong growth, he wrote in a July investment strategy report.

“The narrative has already has begun to take its toll on the earnings outlook across the region, with the earnings upgrade cycle turning negative for the first time since the beginning of the year,” noted Siu.

His advice: investors should exercise caution in the third quarter and wait for lower levels to provide better entry opportunities.

Moreover, the Goldman Sachs report raised another red flag: Asia is poised to enter phase three of the business cycle, marked by below-trend and declining growth. This phase is typically associated with negative returns and is typically challenging for equity markets, said the bank.

The report says there are four phases in the business cycle: growth above trend and accelerating; growth above trend but decelerating; growth below trend and decelerating; and growth below trend and accelerating.

Historically returns have been weak in the three months following a six-month period of market outperformance, said the report. “The cushioning factor [this time] is that first-half gains were largely driven by earnings revisions and forex appreciation, not valuation expansion.”

Goldman’s macro forecasts suggest a shallow dip in economic activity below a mildly positive trend, so the bank said it expected a much milder correction in Asian stocks than the median historical level.