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THE year 2018 began on the same note on which 2017 closed - with global equity markets rallying on the back of positive investor sentiment. Despite the recent correction across global equity markets, equity valuations remain high. This may pose a dilemma to those investors who still have cash sitting on the sidelines.
In times like these, the question is whether investors should invest at all? It is a dilemma that they would face not just for equity markets but for fixed income markets as well, where yields are low and credit spreads are tight from a historical perspective.
To understand the current investment environment, let us take a step back to look at the broader macroeconomic environment and the outlook for the equities and the fixed income markets.
IMPLICATIONS OF MACROECONOMIC ENVIRONMENT
Last year, economic growth accelerated across most of the major global economies. This acceleration in growth was consistent and broad-based since the global financial crisis. In our view, aggregate global growth should continue at its current rate or faster as 2018 progresses.
To address a key concern among investors, we acknowledge that the US cycle is in its later stages but we see few signs of a recession on the horizon.
Earlier concerns about very low inflation or even outright deflation in the major economies have dissipated. Inflation has stabilised across the major economies and it is likely to persist at its current pace, with a risk to the upside.
On the monetary policy front, many central banks are expected either to tighten their monetary policy or to stay on hold, such that monetary policy can be expected to tighten at a gradual pace in aggregate terms. Investors should note that gradual tightening will be more easily absorbed by markets and thus, less likely to trigger sharp sell-offs. With this in mind, investors should be on the lookout for any risks of more rapid policy tightening. This could happen should inflation rise which will have a negative impact on asset prices.
Considering the above factors, our view is 2018 will be a year of improving economic growth, of gradually rising inflation and of gradually tightening monetary policy. Such a scenario implies that risky assets could perform, but the market backdrop would be a more volatile one given the tendency for markets to swing between inflation and growth scares.
Investors may be reluctant to invest new money when asset valuations are high. This is because of a higher risk of the asset price falling when valuations retrace to levels which are more consistent with the asset's long-run average.
However, they should note that high valuations do not always mean a retracement is imminent, although it does suggest that long-term returns are likely to be lower. Both equities and fixed income markets can remain at higher valuations for extended periods of time. During these periods, the assets may continue to generate returns for investors and as such, high valuations should not be an automatic barrier to putting new money to work.
The more fundamental question investors should ask when faced with high valuations is whether there are reasons for those valuations to retrace. If they expect those valuations to remain stable or to continue to rise, then they may consider staying the course or adding to their existing investments.
From our perspective, prices are likely to be supported as in the past, the primary trigger for a large sell-off has been a recession, or signs that one is impending. Given the weight of the US economy in the global economy and global equity market, it is a US recession that generally concerns investors.
At 104 months old, the current US economic cycle is already one of the longest in history. Consequently, questions are being raised on the viability of continued growth in 2018. While we recognise that this is a risk, we do not share this scepticism as economic cycles do not 'die of old age', so to speak. Since World War II, the primary cause of US recessions has been rapidly tightening monetary policy or oil shocks. Currently, neither is the central scenario for 2018. As central banks eventually exit from ultra-easy monetary policy, higher valuations will be challenged and therefore, critical to the outlook for 2018 is rising inflation.
We like equities as they are likely to move higher on stronger earnings but valuations are unlikely to re-rate higher given a tighter monetary policy environment. Broadly speaking, we expect equities to deliver better returns than fixed income in 2018, given the low all-in yields for most fixed income asset classes.
Markets outside the US, including Europe and emerging markets, are not yet showing late-cycle conditions. Equities in these markets may be attractive as they could present more upside opportunities.
Asian fixed income consists largely of USD-denominated bonds, whose price returns depend on US interest rates and credit spreads. US interest rates are on the rise as the Federal Reserve (Fed) is in the midst of its tightening cycle. We expect it to deliver three interest rate hikes in 2018, in line with industry forecasts which mostly range from two to four hikes. Credit spreads are expected to be tightened slightly as they are already near or at historical lows. Taken together, the outlook for US interest rates and credit spreads suggest that price returns on USD-denominated bonds are likely to be very modest, possibly even slightly negative. These price returns, when combined with the regular coupon payments from bonds, are likely to result in total returns for fixed income in the low to mid-single digits.
Investors who still prefer fixed income assets may wish to consider venturing beyond the usual, familiar segments for better value. One segment to explore is US Treasury Inflation Protected Securities (TIPS) and other inflation-linked bonds. These bonds increase their returns to investors when there is an increase in inflation. As inflation in the US remains low by historical standards and the risk is to the upside, these bonds may offer investors a cheap embedded hedge against higher inflation.
For investors who are familiar with local currency bond markets in emerging economies, these assets may be a potential source of value. However, we advise that investors do their homework when investing in these assets. A higher risk of socio-political developments could affect local currencies and/or the interest rates in these economies. Alternatively, an external professional adviser may assist investors with the active management of their fixed income portfolios.
In 2018, we advise investors to be mindful of the catalysts for a pullback in valuations. That said, markets are expected to stay volatile, providing shorter-term, tactical investment opportunities. Investors should consider buying hedges when they are cheap and take advantage of volatile episodes as buying opportunities.
They may consider using option structures to limit downside risk without sacrificing the upside potential of the investment. The addition of some alternative assets including hedge funds and commodities would also help with diversification.
- The writer is chief investment officer and head of investment products and solutions, UOB Private Bank