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EVEN though we started 2016 with a view that markets were likely to trade in a broad range with higher volatility as the Fed normalises policy, we were surprised by the extent of the sell-off in January and February. Despite the volatility, we saw that market fundamentals remained sound and fears of a sharp slowdown in global growth was unwarranted. We were convinced, at the height of the sell-off, that the fearful market sentiment presented an attractive opportunity.
Taking a contrarian view, we tactically raised equity to overweight from neutral in February. From its mid-February low, global equities rebound by 15 per cent, with Europe leading the pack at +17 per cent and Japan underperforming at +11 per cent. More recently, the profit-taking that started in April extended into May as the market started to refocus on the Fed's next move. Reflecting growing concerns of a potential Fed rate hike in June-July, Asia Ex-Japan again bore the brunt of the pullback since equities peaked on April 20. On the back of the rebound from February's low leading to less attractive valuations and in anticipation of a potential pick up in volatility given the heavier political agenda in 2H starting off with the UK referendum, we lowered equities to neutral in the beginning of June.
Heading into the second half of 2016, we continue to see the steadily recovering global economy led by the US remaining as a stable backdrop for equities. While we think that the impact of Brexit will be largely contained within the UK and to some extent Europe, we expect political contagion to be of a greater concern for global investors, which suggests more uncertainties ahead. Hence, we are lowering our overall stance on equities from neutral to underweight and advocate a more defensive asset allocation posture. Reflecting our current risk-off stance, we are lowering European equities to underweight in favour of US equities, as the latter is likely to be more defensive given the US economy's underlying resilience.
US: Relatively more defensive but mind Donald's Trump
US equities remained relatively low beta amid the volatility during the first half of 2016. Looking ahead, we continue to see the ongoing recovery in the US economy supporting domestic consumption as well as global growth. With the recent turbulence in global equities on the back of the unexpected Brexit outcome, we expect rate hikes to be further delayed as the Federal Reserve assesses implications from Brexit. With rising uncertainties as the UK embarks on the process to withdraw from the European Union (EU), US equities should be more defensive given the underlying economy's resilience and hence we are upgrading our stance on US equities to overweight. We continue to be positive on consumer discretionary as US consumption growth would continue to benefit from the combination of strong labour markets, solid household balance sheets and improving housing market. Near-term, politics is a potential risk factor with Donald Trump securing the Republican nomination.
Europe: Political agenda dominates
In April this year, we turned Neutral on European equities as we anticipated increased market volatility associated with Brexit. While European equities held up relatively well prior to the UK referendum, the region suffered the brunt of the sell-off following the unexpected Brexit outcome in late June. Financials, the largest sector within MSCI Europe, underperformed as investors de-risked. We expect financials to continue to underperform, in particular capital market-oriented banks, on the back of greater economic and political uncertainties.
Looking ahead, market uncertainties will continue to dominate as the UK embarks on the process to withdraw from EU. This could take a few years for the trade treaties renegotiation process to run its course with various countries. We advise investors with large overweight European positions to use short term rallies to trim positions.
Political contagion is of greater concern in our view, especially if the Brexit outcome emboldens other anti-EU populist parties to demand similar referendums in their countries. Looking ahead, the Spanish elections and the formal conclusion of the Greek review are other events on the geopolitical watch list. With forward PE of 15x above the long-term average of 12x, valuations are not yet at attractive levels. In line with our preference to stay defensive in a risk-off environment, we are lowering Europe to underweight from neutral.
Japan: Slings & arrows
Japanese equities had another difficult first half this year. The fourth quarter full-year 2016 results season disappointed and consensus earnings estimates were downgraded further. Near-term, economic and corporate earnings growth outlook remains uninspiring. The USD/JPY spike in late June as a safe haven currency following the Brexit vote drove the equity market even lower.
Looking ahead, the rising possibility of Bank of Japan easing to stem currency strength could provide a tactical lift for the market but sustained re-rating of Japanese equities would require more impactful structural reforms, especially after the recent Upper House election. Valuations however, at PE of 13x, are not demanding. We stay Neutral on Japan and prefer companies with high earnings visibility.
Asia Ex-Japan: Resilient amid Brexit volatility
Fundamentals for the region, ranging from China's economic activities to regional corporate earnings growth outlook, have started to soften again. Asia Ex-Japan equities remained relatively resilient amid the recent bout of Brexit related volatility helped by the region's lower direct trade linkages. Philippines and Indonesia outperformed while Hong Kong and China underperformed.
The prospect of delayed US rate hikes could potentially cushion the growth outlook for the region, which has started to soften again. On the other hand, with valuations undemanding, we maintain our Neutral stance. Within the region, we continue to prefer China and Singapore, which trade at undemanding valuations. China continues to face a "Stop-Go" policy approach, which would cap overall growth prospects as the government continues to reign in the credit issues. Nevertheless, new economy sectors have been able to power ahead amid this backdrop and we continue to advocate switching into these domestic-demand, services-based sectors. Within South-east Asia, we favour Indonesia property, Thailand healthcare and regional infrastructure beneficiaries.
Global Sectors: Preference for cyclical names
Our preferred global sectors are consumer discretionary, healthcare and technology, particularly those listed in the US with limited exposure to Europe. We remain positive on the technology sector - especially names with substantial exposure to consumer demand and continue to see the recent weakness as a buying opportunity. Healthcare outperformed in recent months as investors continued to look for bargains here, following the sector's earlier pullback. The sector still trades at a discount to global equities despite healthy fundamentals. Pricing power for drug and biotech companies are expected to remain strong. M&A activities have further strengthened their edge as well as provided some floors to the sector's valuations.
Investment themes: Innovation
Investing in innovation provides opportunities for alpha returns but the challenge for investors is to identify investible opportunities in innovations that have the potential to change our world in a sustainable way. We see nine key themes that have the most potential to grow exponentially, bringing along significant economic benefits to companies that produce and use them - financial services innovation, 3D printing, big data & analytics, bioinformatics, networks & computer system, nano-technology, robotics, energy & environmental systems and medicine & neuroscience.
Undeniably, the Internet of Things - increased machine-to-machine communication - machine learning and artificial intelligence are showing enormous ability to transform our world and are just some examples of innovation within big data and analytics. Gene sequencing and neurochemistry are providing innovations in healthcare which have the promise to radically improve our quality of life. However, innovation is not limited to the tech and healthcare sectors. Themes such as Nanotechnology, Energy and Environmental Systems, Robotics and 3-D printing have widespread applications across other sectors as well.
We have recently teamed up with Morningstar to introduce the Morningstar Exponential Technologies Moat Focus Index in Asia. This leverages Morningstar's unique, long-term approach to stock analysis and includes a collection of undervalued high-quality businesses that are expected to generate returns on capital above their cost of capital.
The writer is head of equity research, Bank of Singapore