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Until now, Merrill Lynch has deviated from its quantitative model in only very small ways. This month, the firm felt it was necessary to diverge from the model in six ways, and it is in the process of reviewing its methodology. Going against its quantitative model, Merrill Lynch upgrades Australia, China and Hong Kong while downgrading Singapore, India and Korea.
ôSimply stated, our model assumes a rational market, whereas events of three standard deviation proportions are occurring, all around the world,ö says Mark Matthews, a Hong Kong-based strategist at Merrill Lynch. Matthews and a team of strategists in Hong Kong, Australia and Japan work on Merrill LynchÆs Asian investment weather forecast report.
Singapore was Merrill LynchÆs largest overweight in August and its quantitative model shows that it should be kept at a significant overweight. However, last month, Merrill Lynch analyst Andrew Maule downgraded Singapore banks to an underweight, while Merrill Lynch analyst Kar Weng Loo is underweight on the property sector. Since those two sectors account for around half the capitalisation of the Singapore stock market, Merrill Lynch has downgraded the entire market to an underweight.
Australia has gained from SingaporeÆs loss. The quantitative model gives Australia a neutral score, which is already a sharp improvement from the heavy underweight it was assigned in August. However, Merrill Lynch is transferring the excess holdings in Singapore to Australia, leading to the latter receiving the strongest overweight within the regional portfolio.
Merrill Lynch Australia economist Peter Osborne forecasts domestic economic growth to be well below the trend level over the next two to three years, as households consolidate their balance sheets. However, in todayÆs chaotic environment, MatthewÆs team sees Australia as relatively better positioned than other markets in the region.
Matthews points out AustraliaÆs merits. It is the cheapest market in the region when compared to its composite valuation of the past 10 years. The Reserve Bank of Australia was raising rates when most central banks in the region werenÆt, so has more scope to cut them. As a developed market, management quality and transparency are generally better than elsewhere in the region, which should command a premium in times like these. And it is unique in that 9% of employeesÆ salaries must go into a superannuation fund, which invests in equities as well as other asset classes.
For the first time, the quantitative model shows that India should be an overweight, but Merrill Lynch has assigned the market a neutral weighting instead.
IndiaÆs earnings growth is forecast at around 29% for the coming year, much higher than any other country, providing a big lift to the market in Merrill LynchÆs quantitative model. However, Matthews and his team notes that over half of that growth comes from one company û Reliance û which has a large gas pipeline starting next year. Excluding Reliance, IndiaÆs earnings growth drops to 12%.
Plus, IndiaÆs current account deficit is forecasted at 3.1% for 2008, while the rest of the region is in surplus with the exceptions of Australia, Pakistan and Korea. This dependence on capital inflows makes India especially vulnerable given the global financial crisis.
Likewise, Merrill Lynch is assigning Korea an underweight event if the quantitative model shows that is should be a mild overweight.
Merrill Lynch economist Arthur Woo argues that a much weaker-than-expected set of macro data in August indicates a rapid slowdown in the Korean economy. The current account is now at a $4.7 billion deficit, the largest recorded since 1980. However, the Bank of Korea is not capable of cutting rates to stimulate the economy given the continuing fall of the won, which has weakened about 30% in the past year. Merrill Lynch Korea head of research Bryan Song adds that the equity market is unlikely to undergo a structural rebound until there is a stable foreign exchange market.
Merrill Lynch is placing the proceeds from India and Korea to overweight China and Hong Kong, even if both would otherwise be neutral under the quantitative model.
The regionÆs best-performing market in 2007, China, has been one of the poorest performers year-to-date. H-shares have fallen 54% since their peak in end-October versus a 38% drop for the region. Like Australia, China has the capacity to loosen monetary policy against a backdrop of slowing global growth.
Merrill Lynch China economist Ting Lu expects a sea change of mentality among top policy makers in Beijing soon, similar to the reversal in austerity measures in 1998, during the Asian crisis. Policies are expected to be geared to stimulating the economy.
In Hong Kong, the Hang Seng index is trading at a 10 times trailing price-to-earnings ratio. On four previous occasions when the P/E fell below 10 times, the market then went on to rally strongly over the following 12 months. Plus, Hong KongÆs economy is integrated with ChinaÆs, which explains to a degree why it has been more resilient than the rest of Asia. Aggressive measures from China to counteract the global slowdown and financial crisis are expected to benefit Hong Kong.
Malaysia is Merrill LynchÆs heaviest underweight, and thatÆs in line with its quantitative model.
Malaysian earnings have been relatively uninspiring. Only a fifth of companies reported better-than-expected consensus earnings in the second quarter, while 44% came in below. Merrill Lynch analyst Melvyn Boey expects more downward pressure on earnings to follow in the coming months. The weaker-than-expected crude palm oil price, slower growth and higher-than-expected interest rates are some factors that could drive earnings lower.
In constructing the model portfolio, Merrill Lynch looks at five variables.
Three of those variables are based on estimates: the forecast change in each countryÆs currency versus the US dollar between now and the end of 2009; a comparison between the most recent quarterly GDP reading and the Merrill Lynch economics teamÆs full-year GDP forecast; and the consensus Institutional Brokers' Estimate System (IBES) 12-month forward earnings forecasts.
The two remaining variables calibrate the model with realism: the ERR calculated by the Merrill LynchÆs quantitative research team; and a composite valuation measure of dividend yield, trailing P/E, forward P/E, P/cash flow and P/book value.
Benchmark weighting versus the Merrill Lynch model weighting:
Australia û 29.18 vs 32.22%
Hong Kong û 9.15% vs 10.47%
China û 15.92% vs 16.93%
Indonesia û 1.81 vs 1.95%
Thailand û 1.54 vs 1.60%
Philippines û 0.54% vs 0.13%
India û 7.54% vs 7.02%
Taiwan û 11.51% vs 10.96%
Singapore û 5.14% vs 4.27%
Korea û 14.70% vs 13.47%
Malaysia û 2.83% vs 0.84%
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