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EARLY Monday, Singapore sovereign wealth fund GIC warned about stretched market valuations and investor complacency despite looming risks.
It stressed that high valuations and low economic growth rates might weigh on future returns.
In reviewing the performance of markets, Schroders noted that rising equity markets and low volatility have raised the question as to whether investors are becoming complacent, especially against a backdrop of falling bond yields and elevated political uncertainty.
The research house said that investor complacency was evidenced by the new lows seen in the Chicago Board Options Exchange (CBOE) Volatility Index, often referred to as the "fear gauge".
"It could be argued that volatility is low because investors are now comfortable with the three primary factors that have driven volatility in recent years," said Keith Wade, Schroders chief economist and strategist, and Azad Zangana, its senior European economist and strategist.
"Specifically, concerns about the Fed tightening monetary policy, China's currency policy and the oil price have all eased."
The two added that the low level of volatility today could also be due to the favourable political outcomes in Europe, where there has been no swing towards populism.
The economists warned that the next shock to markets might not be driven by the US Federal Reserve, oil or China, but could be geopolitical in origin, "for while political risks may have eased in Europe, they are building in Asia".
"The greatest worry is on US interest rates where the market appears to be underestimating the potential for higher rates. The desire to normalise remains high, and rates are still well below where most models would have them, given where the US is in its economic cycle."
They noted that the current market is only discounting one or possibly two more rate hikes to the end of 2018. Meanwhile, the Federal Open Market Committee (FOMC) members put rates at just over 2 per cent at the end of 2018.
The economists suggested that complacency might be hard to resist as pressures would not become apparent until later.
"Low inflation will keep the Fed cautious, and the start of balance sheet reduction will probably see the Fed pause rate rises for six months to monitor any more general tightening of financial conditions.
"Unless the Fed signals otherwise, the difference of opinion between the market and the FOMC may not be resolved until spring next year. Meanwhile, central bank asset purchases are likely to continue to expand.
"In this environment, investors may find it hard to resist being 'complacent' as liquidity will continue to drive markets with the risk that they move into bubble territory."
So far this year, equities have been the best asset class to be invested in. Commodities have been the worst with oil having re-entered bear market territory despite production cuts by the Organization of the Petroleum Exporting Countries (Opec). Gold has been relatively resilient.
Among equities, Europe and emerging markets were the leading performers, helped by better risk sentiment and a softer US dollar which has been one of the weakest currencies this year so far.
In the fixed income world, the best performance within government bond markets came from UK gilts as a slowing economy and "Brexit" uncertainty made the safe haven asset more attractive. US Treasuries also performed well, although most of this was as a result of the unwinding of the "Trump trade".
As for credit markets, US markets outperformed their European peers comfortably, against a backdrop of falling bond yields but rising equity markets.
Amongst currencies, the euro and yen have both performed well on a trade-weighted basis, while the US dollar has depreciated. Most other currencies have remained stable.