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TRUSTED ADVISER

2018: A year of two halves

Market momentum going into 2018 is "very strong'' but the question is – when will markets start to look at central bank balance sheets and start to be concerned?

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DONALD Trump’s accession to the US presidency in November 2016 was initially met with dismay, particularly in Asia, where fears of protectionism and uncertainty over the future of the Trans-Pacific Partnership Agreement prevailed.

Now, nearly 15 months into his presidency, US economic growth has picked up and the rest of the world has seemingly followed suit. Investors profited handsomely in 2017, thanks to a Goldilocks environment of low interest rates, synchronised economic growth and improving corporate earnings.

Sean Quek, Bank of Singapore head of equity research, says market momentum going into 2018 is “very strong”, but he is cautious. “We’re getting to a level where valuations are no longer as supportive. Our expectation is that the momentum will continue, but the question is – when will markets start to look at central bank balance sheets and start to be concerned? We expect markets to be more challenging as we progress through the year.”

In early 2017, there were a number of factors that boded well for the year – expectations of deregulation under the Trump administration, tax reform and the much vaunted infrastructure spending. The uncertainties, on the flip side, included tariffs on trade and anti-immigration measures.

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BOS’s call at the start of 2017 was for the US to lead equity returns. If policies had panned out on the negative side, Asia was expected to fare the worst compared to Europe and Japan.
As it turned out, Asia ex-Japan was the best performing region with returns of 43.7 per cent for 12 months to mid-January. Returns from US markets came in strongly at 25.8 per cent, but they lagged Europe (30.3 per cent), Japan (29.6 per cent) and the World Index (26.6 per cent).

Mr Quek says 2018 could turn out to be a year of “two halves’’ for the US, typically the bellwether for markets. In the first half of 2018, the indicator that he is watching closely will be corporates’ capital expenditure. In the second half, the question will be whether expectations of deregulation pan out.

So far, indications of US business confidence show a strong uptick. For instance, 2017 came in as the strongest year ever in the history of the NFIB Index of Small Business Confidence data. NFIB said strong economic growth, massive tax cuts, job growth and expectations of higher pay have made for an “exceptional’’ showing.

US consumer confidence is also near an all-time high set in November, fuelled by a strong job market and the stock market’s ongoing bull run. Globally, industrial output is also seeing a revival.
This uptick in “animal spirits’’ is expected to be further reflected in increased capital expenditure by companies. Since 2012, capital expenditure among companies has sagged particularly as oil prices tanked and companies remained uncertain about global demand.

The global manufacturing purchasing managers’ index (PMI) climbed in 2017, reflecting renewed momentum in output and new orders.

Mr Quek says there are, however, reasons for caution. One is that strong economic data could spur the Federal Reserve towards more aggressive rate hikes. So far, the consensus expectation is for the Fed to raise rates twice in 2018. Now more banks – BOS among them – expect four hikes this year.

Mr Quek says: “Policymakers are looking to normalise. The central banks’ balance sheets have expanded over the past seven years. We expect this to peak in the third quarter.

“If we buy the argument that money printing has flowed into assets, especially liquid assets, then that mega trend could reverse or stop, and could turn from a tailwind into a headwind. But the pace of that unwinding should be slow and steady so that shouldn’t create too much of a headwind.’’

Inflation, he says, bears watching. “The consensus forecast for growth is very positive and the forecast for inflation is low. We could have a surprise on growth, and a negative surprise on inflation. Traditionally at this stage, inflation should be higher. If it starts to pick up, the Fed could move interest rates higher... From the valuation point of view, some justify high valuations with low rates, but that justification could now go away.’’

Valuations in the US, he says, look expensive. “We have surpassed the pre-crisis level in valuations, but they’re still lower than the Internet bubble days.’’ Based on another indicator – the market capitalisation of US stocks as a proportion of US GNP – the ratio shows 1.2 times, the highest in the past 20 years.

Yet another indicator is the Shiller PE, also referred to as the cyclically adjusted price-to-earnings ratio. Based on the ratio of about 32.7 in mid-February, the indicative risk-reward ratio over the next 12 months is poor, with a greater probability of loss rather than gain. The MSCI World Index is also trading above its 10-year average PE multiple. The ease with which markets sold off and volatility spiked in late January has clearly reminded investors that momentum has been a key driver in market performance.

Mr Quek suggests four courses of action. One is to seek out diversified exposures that limit risk. Structured products provide an alternative, he says. This may be in the form of a put option to hedge the downside risk of a stock. A structured note may also offer market exposure to stocks or even a basket of currencies, and carry an implicit capital protection where clients who hold the note to maturity get at least their capital back. “We think some form of capital protection has become more important in the overall strategy as the market is expected to pull back.’’

A second course is to adopt rotation strategies. This means trimming exposure to sectors or stocks that have done well, to reinvest in those that are undervalued. One example is to lighten up on technology exposure and reinvest in finance stocks. Banks and finance companies stand to gain as interest rates rise. On Chinese stocks, investors could also lighten up on ADRs (American Depositary Receipts) to shift into China’s A-share market. More than 200 A-share stocks are expected to be included in the MSCI Emerging Markets Index this year.

A third option is to raise exposures to alternatives that will offer diversification benefits for the portfolio, thanks to lower or even negative correlations to traditional assets. These strategies include private equity and hedge fund strategies such as long/short funds that are able to shortsell stocks.

Four is to monitor your portfolio’s risk level. At a time when global markets, particularly the US, are elevated, investors are likely to find themselves with outsized exposures to technology winners such as the FANG (Facebook, Amazon, Netflix and Google) and BAT (Baidu, Alibaba and Tencent) stocks. These exposures may arise simply from holding exchange traded funds (ETFs).

“We ask investors to spread the risk, take profit on some winners. Also, manage the risk. Cash levels are coming down, borrowings are up. It helps to keep your powder dry rather than go all the way into markets.”

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