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As I noted recently, with the potential Fiscal Cliff looming, investors may want to shed their home country bias and consider increasing their exposure to international equities. One exception is Taiwan, which we are downgrading to neutral from our previous overweight.

Here's why:

Weak earnings, especially in technology
Taiwan's economy and stock market is heavily weighted towards technology, representing more than half of the index. Not surprisingly then, the market has been under tremendous stress, falling 6% in October, amid concerns on the weak reporting season in the US. In the semiconductor business, for example, inventory levels have surged recently, resulting in lower capacity utilization rates, which are generally associated with less pricing power for companies, and posing near-term headwinds. Meanwhile, weak global capital expenditures and sagging consumer demand adds pressure on the personal computer market.

Still, even after the October underperformance, Taiwanese equities look a bit rich. The forward price to earnings multiple has yet to show visible sign of a correction, which we think increases the risk of stock prices falling further, and is at odds with the dimming outlook for corporate earnings.

Anemic domestic consumption
While there are tentative signs of export recovery and stabilizing industrial production, consumer sentiment has been dampened. This is a result of a negative wealth effect trickling down from the trade sector, but also from falling household income, which has been hit by tax hikes. And looking ahead to next year, room for further export expansion is likely to be limited.

Inflation pressure on the rise
For the past three months, headline inflation measures have been persistently above the 2% inflation target set by the central bank, a result of higher fuel, electricity and food prices. But in light of already low interest rates and worsening inflation, we suspect that there is less scope for monetary accommodation in Taiwan.

Policy missteps
Rumors on the insolvency of the Taiwan social insurance fund has fueled the fear that the corporate sector will have to carry higher burdens on pension contributions in the longer term. The government has already announced that it will reveal a draft proposal on the pension system reform in next three months. Given that the government's popularity is now at a record low, there is a non-trivial risk of policy missteps that would shake the markets.

Given all this, we would therefore err on the side of caution and move Taiwan to a neutral allocation. However, we still believe investors should overweight emerging markets, and we prefer Brazil, China and - for those with a high tolerance for volatility - Russia.

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Source: 4 Reasons Not To Taiwan On