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Are we at the end of the equity cycle?
FROM my conversations with clients in recent weeks, I gathered that the overall sentiment remains one of "cautious optimism". Our clients are comforted by the fact that global macro conditions remain sound, and the US Federal Reserve has made a U-turn on interest rate policy. But concerns about the US-China trade war continue to linger and cause much discomfort.
More importantly, the sharp rally we saw in the first half of 2019 had investors questioning whether markets are looking "toppish", and if this means we are currently at the end of the market upcycle. Understandably so. The S&P 500 has broken new ground: it is undergoing its longest bull run ever since hitting a trough in early 2009, and has also intermittently breached the 3,000 psychological barrier in recent times.
So where do we now stand, at the mid-point of 2019? Here are some observations I would like to share.
Stock market rallies do not die of old age
History shows that bull markets can last for prolonged periods. A case in point? The 15-year rally on the Nikkei 225 from the 1970s to 1980s.
We should instead consider the macro outlook as it is a more significant determinant of market corrections. Based on the Fed's forecast, the probability of a recession remains low this year.
We echo the same view, that while trade issues have dented the global growth outlook, a recession looks unlikely this year as governments have the ability to conduct fiscal stimulus measures in addition to the Fed's dovish tilt.
"What about the yield curve inverting?", you may ask. We believe that concerns over yield curve inversion, typically a harbinger of a recession, are unfounded.
Our analysis concluded that the US Treasury yield curve is no longer an accurate predictor due to distortions caused by years of quantitative easing. In fact, long-term yields have been artificially suppressed by weak term premium, as well as negative bond yields in some developed economies.
Market rally backed by robust corporate fundamentals
Today's market rally is also backed by strong corporate fundamentals. This is a clear differentiating factor from "toppish" markets, which would normally see a build-up of froth - situations where prevailing market prices become detached from underlying fundamentals. A clear case in point was the dot-com bubble. Between 1995 and August 2000, the S&P 500 rallied 230 per cent but earnings (12-month trailing earnings per share) only climbed 80 per cent. The situation today is vastly different. Since 2010, the S&P 500 has rallied 164 per cent and this is matched by a 158 per cent gain in earnings.
With this robust earnings gain, I believe the S&P 500 is trading at a reasonable price, and so am of the view that we are not at the end of the equity cycle just yet.
Positive yields remain scarce
You may ask - what about bonds? After all, corporate bonds are traditionally where investors hunt for higher yields.
In today's climate of declining interest rates, we are seeing more negative-yielding bonds. This applies not just to the investment grade bond market, but in the speculative grade or high-yield bonds too.
In Europe, about two per cent of the BB and lower-rated market currently have turned negative yielding. In the global investment-grade market, negative-yielding debt remains elevated at around US$13 trillion - almost a quarter of the investment-grade universe!
With G-3 central banks looking set to cut policy rates, I do not see the negative-yielding bond phenomenon changing anytime soon.
As a result of this unprecedented situation, the segments we have been advocating such as BBB/BB-rated corporate bonds and dividend plays such as SReits, have done well given the relentless hunt for yield.
Indeed, at current levels after a 20 per cent appreciation year-to-date, SReits are no longer cheap. But we must consider the backdrop of negative-yielding bonds worldwide. From that perspective, the five per cent yield offered by SReits today remains attractive. In fact, we continue to see interest in the SReits sector from investors of home markets where rates are zero, like the Japanese institutions.
Equities remain "the only game in town"
So, what does this all mean?
As government bond yields continue to head south and cash rates stay near zero, I believe equities remain the only game in town. Investors should not only be looking at equity valuations in isolation, but in relation to other assets. After all, the pool of global savings would need to find a home and there are only three asset classes - cash, bonds and equities - that can absorb these funds.
From an overall portfolio approach, I continue to advocate a "Barbell Strategy" to investing. A Barbell Strategy splits your investment portfolio in two: with secular growth assets on one end, and income-generating assets on the other.
On the growth side, seek opportunities in technology, consumer discretionary and healthcare stocks. These are companies which will benefit from long-term irreversible trends, like the global shift towards digitalisation or the ageing population.
And on the income end, stock up on bonds and dividend stocks such as USD BBB/BB-rated corporate bonds, SReits, and the "big five" Chinese banks for a steady cash flow. These are assets that will pay you dividends as you hold them, therefore adding resilience to your overall portfolio.
Having income-generating assets in such a portfolio will give you confidence to stay in the game for the long run. Keep in mind it is normal, from time to time, that we see broad market corrections which will impact growth stocks in the short term.
- The writer is chief investment officer, DBS Bank