Region ready to absorb impact

Will interest rates go up in the second half of the year? That's the question on everyone's mind at the moment, whether it be a chief financial officer or a prospective property buyer in Hong Kong.

Some analysts believe the United States Federal Reserve will consider raising interest rates towards the end of the year as the world's biggest economy slowly limps back to recovery.

And if interest rates do go up, what areas should high-net-worth investors be looking at to improve their portfolios?

Ignatius Chong, head of private banking for north Asia at RBS Coutts, says that while active trading and leverage are still very much in demand, there is an increasing awareness of the importance of asset allocation and sound portfolio management.

'Unsurprisingly, there is much more interest now in risk management. Hong Kong clients have begun to depart from speculative investment and become more open to understanding and managing risk. Similarly, mainland clients are increasingly mature in their investment appetite and wealth needs,' Chong says.

While equities have been volatile this year, what is the most appropriate product available to wealthy investors?

The Royal Bank of Scotland (RBS) believes the cost of capital should increase - a big change from the prevalent trend of falling bond yields over the past 30 years. The bank says in its report, 'The Asian Angle: Regional Asset Allocation Guide', that the most important implications for equity investors are that real returns will be lower and volatility higher, in Asia and globally.

The report is a quarterly view of the Asian financial market and asset allocation by country and sector.

Likewise, Marc Van de Walle, managing director and head of product management at the Bank of Singapore, says there are clear indications that interest rates will continue to rise in Asia.

He points to the fact that China and India, two of the fastest-growing economies in the world, have already raised interest rates several times in recent months.

Van de Walle says the Fed is also expected to raise interest rates at some stage but this process will take more time given moderate growth in the US, possibly later in the year or early next year.

So how will rising interest rates affect Asia?

The RBS report says that overall this change in environment will have less impact on Asia in general as the region is well positioned due to its current account surpluses, generally low public debt levels and aggregated savings surpluses.

RBS is, and has been, upbeat on the prospects for the region.

The investment bank expects absolute returns for equities of between 15 per cent and 30 per cent this year, albeit with continued high volatility.

As such, the RBS Asian team believes regional equities will continue their global outperformance witnessed over the past decade.

'We have seen US$8.3 billion of outflows from Asia, ex-Japan, funds in the first quarter of this year, but we expect positive flows to resume,' says Emil Wolter, head of regional strategy for Asian equities.

'Ultimately, in this changing environment, the determining factor will be which countries are capital self-sufficient and which aren't.'

Wolter says that while Asia has cyclical challenges, they pale in comparison to the continuing structural problems in advanced economies.

Thus Asia's structural advantages, illustrated by persistent yield and growth gaps, are likely to consistently lure back global investors and some speculative funds.

'We believe that equities remain the most attractive asset class as long as the world economy continues to grow,' Wolter says. 'This will continue to be the case until interest rates exceed nominal growth in the main developed economies.'

RBS economic forecasts indicate equities will continue to outperform until long-term bond yields rise by another 200 basis points.

With long-term bond yields (using 10-year US government bonds) at 5 per cent to 5.5 per cent, global growth could start to falter and equities would consequently struggle.

Van de Walle says the Bank of Singapore feels that emerging market bonds are more attractive than European bonds from a risk and return perspective. He says that sovereign and corporate entities in emerging markets enjoy healthy balance sheets, and this enhances their credit quality.

The RBS report also shows that a higher cost of capital will mean that the idea of buy-and-hold equities becomes obsolete and investors will need to pay closer attention to economic cycles and valuations, both of which are likely to become more pronounced and have a greater effect on returns.

Wolter says financial stocks are most likely to benefit in this new environment. RBS has, therefore, upgraded the sector to 'overweight', taking a positive view for the first time in two years, following 800 basis points of underperformance compared to regional shares.

However, John Woods, chief investment strategist, Asia-Pacific, at Citi Private Bank, has a different view than other strategists in that he feels that interest rates would not go higher in the US until the first quarter of next year. He suggests the first rate hike by the Fed could even be delayed to the third quarter of next year.

RBS strategists believe Taiwan and, in particular, its banks - which previously suffered disproportionately as the mainland exported deflation to the world - will be the largest beneficiaries as mainland inflation becomes a problem. Mainland wages have been exceeding nominal gross domestic product growth for some time, illustrating that its supply of cheap labour is not infinite.