DESPITE a credit crisis emanating from the US and fresh highs in oil prices, global stock markets have broken records again this year. In Asia, especially since the August turmoil, investors have experienced impressive returns. Most regional equity indices boast year-to-date gains well above the returns seen in the US or Europe. Economic growth has been strong and regional markets have risen on the back of robust earnings growth, PE multiple re-rating, and strong currencies.

Naturally, the question arises: Can this continue in 2008?

We believe it can. Valuations have increased but do not seem stretched. With the exception of China, PE multiples are not at astronomically high levels. Current PE ratios for the Asian indices (excluding China, India and Japan) range from 14 to 23, which are not a far cry from 18 for the S&P500.

We believe Asia will continue to grow at a respectable pace in 2008, which keeps us positive on Asian equities as an asset class. Asian economies should remain healthy, ie, continue to see more broad-based growth, current account surpluses and lower debt levels. They will also continue to see stronger intra-regional trade - rising dependence on China, in particular, and falling dependence on US demand.

Our central scenario is that Asia will continue to expand at a respectable pace even if below-potential US growth extends into 2008. A gloomier US growth outlook is not good news for Asia, but weak US growth for the past two years has not prevented Asia from accelerating modestly all the while. Another year of 2 per cent growth in the US, should it be that weak, would make little discernible difference to Asia.

We believe the US economy will avoid a recession as the drag from housing construction fades and core consumption remains resilient. We continue to take confidence from the fact that in the far sharper downturn of 2000-01, when 2.5 million Americans lost their jobs, consumption growth remained above 2 per cent year-on-year.

Major risks

It is true that the balance sheets of Asian corporates, like the economies they operate in, are in much better shape than 10 years ago, before the financial crisis of 1997-1998. But although Asian stock markets are less vulnerable than in the past, they are not insulated from developments in the rest of the world.

There are, as always, a number of risks for Asian markets. What are they?

First, on a PE basis, Asia's emerging markets no longer trade at a discount to developed markets. Valuations have been catching up and re-rating (ie, stock price increases per dollar of earnings) over the recent years has helped push many Asian  markets to a premium (Table 1). Clearly, investors are seeing better long-term earnings growth potential in Asia.

Second, on a price-to-book basis many Asian markets trade at higher multiples now than in 2004. China and India, in particular, trade at huge premiums to developed markets. Thailand and Taiwan are the only exceptions, with the SET and the TWSE trading below and near 2004 levels (Table 2).

Third, borrowing costs have risen, as uncertainty has increased and risk has been repriced. This is evidenced by tighter liquidity and wider credit spreads in money markets and steeper yield curves.

It has become more difficult for businesses to obtain loans, not only in the US but also in Europe. Money markets are unlikely to normalise in the near-term but they should function normally again in 2008 after more information on financial sector exposure to certain credit markets has surfaced. If history is any guide, it will take a while before the credit crunch subsides.

Fourth, there is the risk that inflation will eat more aggressively into returns. Markets seem to have forgotten about this amid US growth concerns but policy makers have not. Inflation risk will almost certainly return as a major theme in markets in 2008. Central bankers are sure to remind markets of this.

Bottom line, we remain positive on the outlook for Asian equity markets, but risks surrounding this central scenario have increased slightly in recent months and the earnings outlook has become more cloudy.

Bonds, commodities

The outlook for Asian bond markets is bearish as yields are expected to rise. Inflation risks suggest that central banks will be biased towards tighter monetary policy in 2008. Moreover, inflation expectations, while currently very low, are likely to rise. Sentiment among bond investors is hence likely to be weak and returns in 2008 will be less impressive than in 2007. After a strong showing in 2007 and with slower global growth expected, the outlook for commodities appears less certain now and there are material downside risks in many markets.

Taking all the above into consideration, investors will have to come to terms with the idea that volatility is returning. The recent turmoil in markets likely marks the end of the low-volatility period we have witnessed from 2004 to 2006. But this is not a bad thing. As the swings in financial markets increase, opportunities for investors to achieve high returns increase too. But, as there is no more easy money, it also means that the portfolio approach to investing, ie, risk diversification, is becoming even more important.

The Chicago Board Options Exchange SPX Volatility Index (VIX) reflects a market estimate of future volatility in the S&P 500, based on the weighted average of the implied volatilities for a wide range of options. The Merrill Option Volatility Estimate (MOVE) is a yield curve weighted index of the implied volatility on Treasury options and reflects a market estimate of future Treasury bond yield volatility.

According to modern portfolio theory, investors should assess portfolios based on overall risk-reward characteristics rather than the individual risk-reward characteristics of the constituent securities. Put differently, investors should not assess the risks  and rewards of securities individually but in a portfolio context, ie, how they affect the portfolio's overall risk and return. This is because a portfolio's risk is not only a function of the individual securities' risks but also of their correlations.

Exposure to risk is reduced by combining a variety of securities, all of which are unlikely to move in the same direction. Because not all markets move up and down in value at the same time or at the same rate, a portfolio approach promises more consistent performance under a wide range of economic conditions.

Our asset allocation model, which helps us find portfolios that have optimal risk/return characteristics, suggests that for a 12-month allocation horizon 54 per cent of funds should be allocated to equities, 28 per cent to bonds, 18 per cent to cash and zero to commodities (Figure 1). The resulting portfolio has an expected return (annualised hedged return in SGD terms) of 15 per cent and expected risk (annualised standard deviation of daily hedged returns) of 8.4 per cent. It is an optimal portfolio, given our hedged-return expectations, historical risks, and the historical correlations between markets.

Within the portfolio context we favour Singapore, Hong Kong, China, Taiwan, and Malaysia among regional equity markets; and China,the Philippines, Korea, India, and Thailand among regional bond markets. While some markets are not accessible to all investors, we believe that keeping these markets in our framework provides the best summary of our investment outlook.

For DBS's latest tactical regional asset allocation report and a description of its asset allocation framework visit http://www.dbs.com/research

Jens Lauschke is strategist, group research and Sanjit Maitra is managing director and head of group research. They are with DBS Bank