Time to moderate stock expectations

Singapore

THE bull-run which saw stock markets post exceptional gains last year continued in January, as global equities started the year with a bang and had one of the best starts to the year in decades.

However in the past week, the tide took a sudden and sharp turn as markets posted their worst performance in two years due to concerns about higher inflation and interest rates.

To begin with, the correction is long overdue as stock markets have not had a meaningful pullback in more than a year. Clearly, markets needed a breather. However, the question on investors' minds now is whether the sharp and sudden fall in markets is a harbinger of more bad news and the start of a bear market? Or is the pullback simply a healthy correction and possibly a buying opportunity?

Before we try and answer these questions, let's first explore what went wrong in the past week which caused the swift change in sentiments. Three things happened last week which contributed to the sharp sell-off.

Firstly, US 10-year Treasury yields surpassed the psychologically important 2.7 per cent level early last week. Investors took it to mean that the smart money sees inflation rearing its ugly head and that bond markets could see a sell-off which could spill over into equities.

Later in the week the US Federal Reserve held its first policy meeting for the year and at the end of its two-day meeting, it issued a statement which sounded more upbeat about the economy and inflation. Investors took it to mean that the Fed was starting to prepare the markets for a more hawkish stance under the leadership of new Fed chairman Jerome Powell.

Finally, last Friday, the US job figures for January surprised on the upside as wage growth which had been fairly subdued for many years finally showed some life by posting a reading of 2.9 per cent, the largest rise since June 2009. With the US economy close to full employment and US President Donald Trump's tax reforms expected to boost growth, markets took the view that the labour markets will tighten further and wage growth will surpass the crucial 3 per cent level which could fuel inflationary pressures.

Clearly, equity markets have been very complacent about inflation and interest rate risks for a fairly long time, and the turn of events last week was a reality check.

We are of the view that US 10-year Treasury yields will head even higher, probably to 3.25 per cent in the next 12 months. This is partly due to rising inflation and also because the Fed is shrinking its balance sheet and the US Treasury will need to woo investors with better yields to fund the rising budget deficit which will come with Mr Trump's big tax cuts.

Does this mean that the bull-run has ended and the bears have emerged from hibernation, forcing investors to take cover? We don't think so. We think that the correction is healthy and will offer opportunities to accumulate and bargain hunt for investors with a medium-term horizon.

For one, the economic and earnings fundamentals are still very healthy. The Citigroup Economic Surprise Index for major advanced economies has risen to near record-high levels and we see world economic growth gathering pace this year. Earnings have also surprised on the upside and most companies that have announced their fourth quarter earnings recently have exceeded market expectations. Analysts have also turned more upbeat on the earnings outlook for 2018 in recent weeks given the strong growth momentum.

So while inflation and interest rates are on the rise, investors should not lose sight of a key reason why they are rising - which is effectively better economic fundamentals. However, the raging bull that we saw last year is unlikely to be as ferocious this year and investors need to moderate their expectations about returns.

The reality is that the easy money has been made and strong economic growth, tight labour markets and higher inflation will mean that central banks will tighten monetary policy. Consequently, liquidity, which was a key driver of the bull-run, will become less abundant.

Investors will eventually adjust to this new reality and markets will eventually refocus on the positive fundamentals. So don't lose hope - there is light at the end of the current dark tunnel.

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