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AS markets enter the third quarter of 2014, they remain unusually calm. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, is near record lows. Some market watchers worry about inflation in the United States, which they fear will trigger an earlier-than-expected interest rate hike by the Federal Reserve. But low volatility suggests that they do not know which way to trade. While the consensus is currently for the first hike of the fed funds rate to take place in the second half of 2015, some people, notably St Louis Federal Reserve president James Bullard, said rates could rise as soon as the first quarter of 2015. This is because core personal consumption expenditures inflation, which hit 1.5 per cent in May, is near the 2 per cent mark the Fed is targeting.
Fed Chair Janet Yellen has said recent inflation data is "noisy", but also noted that the Fed "would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective". This implies that should evidence mount that inflation is going to be above 2 per cent for a period of time, the Fed will take action to prevent the economy from overheating by raising rates. Conversely, if the US economy does not look like it is picking up, such as now, the Fed is likely to keep the liquidity flowing. Most analysts thus remain confident in the prospects of equities. This faith in stocks is due to a number of reasons.
Firstly, history shows it is not the first rate hike that kills a bull market. Rather, overnight rates have to rise to above 4 per cent before stock markets begin their downturn. As DBS pointed out, it took 17 rate hikes amounting to 425 basis points in the last US bull cycle before stocks began to decline.
Secondly, with cash yielding near zero, investors have no choice but to keep their money in equities. But inflows into equities started just last year and are not near the frenzied levels seen in previous market peaks.
Thirdly, while there are signs that inflation is picking up in the US through rising raw materials and unfinished goods costs and rising wages, it is still below the 4 per cent mark above which equity valuations tend to decline. Standard Chartered Private Bank said in a recent presentation that historical S&P 500 price-to-earnings (P/E) ratios for inflation in the 2 to 2.9 per cent region are 19.5 times. Current P/E ratios are at 18 times, which makes equities fully valued for inflation in the 3-3.9 per cent range. If inflation is between 4 to 5 per cent, equity valuations drop to 15 times.
Despite many good reasons to stay in equities, there might be hidden geopolitical or market risks investors may not have discounted, including tensions in the South China Sea and spreading conflicts over Iraq or Ukraine - which can cause oil and gas prices to spike. History teaches us that market crashes happen for one reason or another, at unexpected times. Prudent investor will diversify, buy on fundamentals when the market is afraid, and hold cash when everybody is buying.