Where to invest in Asia right now

Former U.S. President Franklin D. Roosevelt once said, "The only thing we have to fear is fear itself."

Proclaimed at the height of the Great Depression, this iconic quote has recently resurfaced as a rallying call to calm investors panicking over the current market climate. We knew 2016 would be a bumpy transition to a new normal, but the year has had a rougher start than we anticipated. The current level of fear, however, is exaggerated.

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Many investors question China's ability to smoothly manage a complex transition; poor trade data, high credit growth and sizable capital outflows are fueling these concerns. We disagree that rising regional banking stress is a precursor to a broad financial crisis or a trigger for currency debasement. The Chinese government, which enjoys low debt, has ample policy room to maneuver and can react swiftly if turmoil eventuates. China has sharply tightened existing capital restrictions, ramped up fiscal spending and eased regulatory policies.

A sharp Chinese yuan devaluation does not serve China's interest – quite the opposite. A significant depreciation would trigger capital flight, curtailing any benefit to growth and runs counter to recent years of structural rebalancing efforts. In fact, for the sense of crisis to fade, we believe China's top priority is to stabilize FX expectations. What's more, the Chinese yuan is arguably no more than 5-10 percent overvalued - how else could China still gain export market shares and record a trade surplus of some $600 billion in 2015?

Due to weaker U.S. growth, we now only expect two U.S. Federal Reserve rate hikes this year and expect reduced U.S. dollar strength. This and benign inflation help regional policy makers by allowing more room to ease monetary policy. Investors should still hedge against weaker regional currencies; broad weakness remains likely, just to a lesser extent. A modest Chinese yuan depreciation to 6.8 versus the U.S. dollar by the end of 2016 is still our base case. Investors should also be mindful of rising interest rates in Singapore and Hong Kong.

Asian credits are showing few signs of stress, with spreads at 320 basis points versus the height of over 800 basis points during 2008 and 2009. Yet, Asian equity markets are in the doldrums, with valuations reaching global and Asian financial crisis levels. While earnings forecasts are likely to edge lower, we still see growth in the mid-single digits and healthy return-on-equity (ROE) ratios.

Such overly bearish investor sentiment and lower Fed rate expectations have created select opportunities. Quality income stocks -- those enjoying stable cash flow and a track record of dividend sustainability across economic cycles -- should perform better this year, amid a slower pace of Fed rate hikes and a renewed regional central bank focus on policy easing.

We retain our preference for Asian equities outside Japan versus Asia credit, where less compelling valuations cap upside potential. Credit fundamentals are weakening, especially in energy and high yield cyclicals although Chinese high-yield bonds still offers a good carry. We stay neutral on Japan; valuations are close to historic lows and we expect the recovery to take time.

Understandably, investors are feeling rattled about the future – talk of a sharp Chinese yuan devaluation, worsening European credit and even a U.S. recession have markets on edge. Short-term growth prospects look weaker than expected, particularly in the U.S., but we do not believe we are in recessionary territory. Housing and employment are still robust in the U.S., and lower household debt is supportive of consumption.

Naturally, slower U.S. growth weakens European and Asian prospects – the impact will be apparent on trade figures. But while this hurts broader regional earnings growth, it doesn't disrupt our key investment thesis for Asia: investors should exploit excessively cheap valuations to add quality stocks with dividend sustainability, particularly amid expanding pro-growth policies.

Commentary by Min Lan Tan, head of the Asia Pacific investment office at UBS Wealth Management.

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