Grace Tam, vice president of investment services, J.P. Morgan Asset Management, talks to Innovative Investor about the Asian markets.

Innovative Investor - What do you think about the outlook for the Asian markets at the in the first part of the year?

Grace Tam - Low OECD growth is likely to keep rates at exceptionally restrained levels. This is good news for Asia but inevitable asset price inflation brings risks with it. With one bubble just burst, policy makers in China, Hong Kong and Singapore, in particular, are not going to be relaxed about seeing another inflate so quickly.

Once the re-stocking bounce has run its course the focus will return to what levels of overall levels of global demand are sustainable going into 2010. What has been achieved so far has been achieved only with exceptional liquidity provisions and with government help in the form of stimulus. Monetary policy will gradually normalise, and the stimulus has to be paid for.

Innovative Investor - Looking at the reports at the moment, what is your best guess as to when this will begin to happen?

Grace Tam - Rising rates and rising taxes seem inevitable at some stage. Individual savings continue to be re-built and commodity prices could add further drag to the recovery. How far out the reversal in 'policy' will occur is difficult to judge. However, in these fears lies the basis of the worry about economies weakening again towards the end of next year.

For now, in Asia, there are three positives to sustain further progress: abnormally low interest rates; an oil price which we believe will stay in a US$60-85 range and, finally, a weak USD. Absent any major negative geo-political events, China and India should continue to do well even during a period in which rates start to rise.

Shorter term we believe the planned Indonesian infrastructure investment should drive further improvements in the economy there. Australia is a difficult call but the economy is being well-managed and demand from China will sustain commodity plays.
We are concerned about top down risks in Thailand and Malaysia and are not optimistic about Japan even if, as seems likely, the JPY weakens from current levels.

Innovative Investor - The challenge for investors is to balance returns with risk - not easy after the losses of the last 18 months - so what trends are you seeing in terms of investors' appetite for risk?

Grace Tam - 2009 has been a great year for riskier assets after a nerve-wracking start as investors have been moving out of cash and bonds into equities amid zero interest rates and quantitative easing. It appears that it is now acceptable to be taking risk once again, as reflected in the stellar year-to-date performance of risk assets.

It looks like if global central banks in general are doing their best to 'penalise' cash holders through very low interest rates. In fact, central banks have an interest in seeing stronger asset prices as this lowers cost of corporate finance and supports household wealth. Recovery in investor risk appetite this year has suggested that this policy is working.

However, too much good news could lead to euphoria and subsequently excessive risk tolerance which could lead to a damaging correction in markets. The rapid recovery in risk appetite makes us nervous, but given cash returns are so low, the equity rally looks sustainable in the short-term.

Innovative Investor - What trends do you see moving into 2010, and what are your predictions for 2010 in terms of areas to follow and to avoid?

Grace Tam - We remain overweight equities versus bonds and cash as we enter 2010. The prime reason for this is that easy monetary policy and economic recovery both traditionally favour equities and are set to continue in 2010. Also, positive surprises to earnings growth could support higher equity prices, notably in Europe, Asia and the Emerging Markets.

The principle dilemma for investors now is whether they should prioritise capital preservation and cut their exposure to higher risk assets, notably corporate bonds and equities or prioritise capital growth.

It appears that the decision is made easier by very low interest rates across the OECD and the fact that G7 government bond yields do not look appealing. For example, US Treasuries are currently yielding 3.3%. Stripping out breakeven inflation of 2.1% leaves a real return of only 1.2% p.a. over the next 10 years.

Yet with many corporate pension funds looking materially underfunded, there is strong pressure on trustees to generate higher returns so as to avoid the corporate sponsor having to inject further cash. Similarly, retail investors will be looking to make up for a horrible 2007-08 and to generate returns that are materially higher than both cash and government bonds.

All these are likely to necessitate investors looking either to increase or maintain active investment positions in equities, corporate bonds, commodities and/or property.

Innovative Investor - With the huge bounce in equities last year what are you advising investors for H1?

Grace Tam - On a 6-12 month view, equities are likely to provide higher returns than both bonds and cash. This is a powerful reason to stay the course in higher risk assets. However, the pace and timing of equity returns will depend on tangible proof of earnings recovery, positive sales and sustainable growth. We suspect stock market returns will be more muted than in past recovery cycles, mirroring the more muted nature of the economic upswing.

Innovative Investor - What regions are you currently most interested in?

Grace Tam - By region, we prefer the Asia and Emerging Markets. They were the major beneficiaries of the Fed easing in the early 1990s, with a sizeable re-rating of these markets. The same pattern may be repeating itself. Emerging Markets are now priced above their long-term average PBV of 1.8x. While no longer undervalued, we nevertheless remain comfortable with their valuations.