Markets deemed still attractive

US rate hike not expected to push US dollar up

STEVE Brice is Standard Chartered Singapore’s chief investment strategist.

He is an expert on the world economy and global markets. He has over 15 years’ financial markets experience in senior positions. His previous roles for the bank include head of global markets (Southern Africa), head of research (Middle East and South Asia) and chief economist (S-E Asia).

Steve started his career at I.D.E.A. Ltd, a financial consultancy in London. While Steve is based in Singapore, he travels frequently around Asia and to the Middle East to share his views with both clients and the media.

Steve is originally from the UK, but has lived in Asia, Africa and the Middle East for the past 15 years. He has a Masters from the University of Liverpool. Steve has been a BeyondBorders author since July 2014.

Steve shares his insights with StarBizWeek on why he thinks the US economy is still strong, why interest rate hikes won’t bring about a higher dollar and why emerging markets are still attractive.

Below are excerpts of the interview:

The Fed has indicated it is going to slowly raise interest rates. The feel is that the US economy is very strong. What is your take on this?

The Fed is probably balancing two aspects. On the one hand, monetary policy settings remain loose, especially when taking into account the weakness of the US dollar and the easing of lending standards. Normally, interest rates broadly track nominal gross domestic product (GDP) growth. Over the past five years, nominal GDP growth has averaged 3.6% and short-term interest rates are just above 1%. This suggests that interest rates could rise significantly.

On the other hand, inflation expectations have fallen markedly in the past few months, which means there is no need for the Fed to hurry, with some even arguing that the Fed should pause until inflation pressure starts to rise.

Taking both factors into account, we believe the Fed will continue to hike interest rates only gradually in order to ensure that it does not undermine the economic recovery prematurely. This gradual approach is reinforced by uncertainty over what is the post-Global Financial Crisis “neutral” interest rate, which some suggest could be as low as 1.5% (the Fed estimates it to be 3%). We expect two to three 25 basis points (bps) interest rate hikes over the course of the next 12 months.

On the US stock market, we have had eight years of expansion. Is this a bull in the matured stage? What is your call on the market now?

It is clearly mature, but we believe it can extend even further. Valuations are getting quite stretched, but they are not at extreme levels relative to history. Meanwhile, after two years of stagnating, the earnings outlook has improved markedly. Earnings are expected to grow around 11% year on year over the next 12 months.

Indeed, the goldilocks nature of the US economic picture – whereby growth is robust and inflation is well contained – should be good for equities both in terms of earnings but also in terms of supporting valuations (as the competition from bonds does not increase in the form of dramatically higher bond yields).

Overall, we prefer the eurozone and Asia ex-Japan equities, but believe US equities are likely to generate positive returns over the next 12 months.

Would you still recommend buying equities at this juncture? Or do you feel it’s best just to hold and do nothing?

The summer months are often interesting in terms of significant drawdowns in global equities. However, there is no hard and fast rule to follow. We believe any drawdown this year is likely to be relatively limited and therefore we would not sell equities in an attempt to buy back cheaper because timing this will be very difficult to get right. Therefore, for those who have yet to take sufficient equity exposure – and our experience is that most investors in Asia remain underweight equities – we would look for any pullbacks as an opportunity to buy.

When do you think is the best time to buy stocks?

Just as the summer is often a challenging period for equity markets, the November to April period has been the best performing period on average. Naturally, though it is always important to look at other factors when taking investment decisions.

On that note, is a “matured bull market” a good time to buy stocks? What sort of stocks should we buy at this stage?

In terms of preferences within stocks, we prefer the more growth oriented areas of the market. We have just closed our China New

Economy and US technology themes following a very strong performance in the first half of the year, and the corresponding rise in valuations, although we continue to like those sectors from a longer term perspective. We have become increasingly optimistic on the outlook for banking stocks, particularly in the eurozone and the US, but also to some degree in China.

At the regional level, we prefer the eurozone and Asia ex-Japan equities given the improving economic and earnings growth outlook and relatively cheap valuations. Declining political risks in the eurozone are also a significant positive with Macron’s election victories not just great news for France, but also for eurozone unity.

In your opinion, are “easy monetary policies” and earnings growth the prerequisites for a bull market? Do bull markets continue anyway with other ingredients?

I generally look at several factors to evaluate the attractiveness of equity markets – valuations, economic momentum, cost pressures, liquidity and currency market outlook. As discussed above, only valuations are really flashing amber at the moment, and even here equities actually look cheap relative to bonds just not versus their own history. Monetary policies are still extremely loose globally, even if they are likely to become less so in the coming months. Earnings have also recovered strongly this year after being weak for some time. This leads us to remain constructive on the equity market outlook over the next 12 months.

Typically how does a bear market happen? Can you give us some of the indicators or signs?

A global recession would lead to a bear market. There are generally two approaches used to judge the probability of a recession – analysis of economic data and analysis of market indicators. Our investment process is to take a blended approach as each area of focus has its strength and weaknesses.

Economists normally only “predict” a recession after it has started. For instance, economists only started predicting the 2001 US recession after the Sept 11 attacks, whereas the National Bureau of Economic Research dates the recession as starting in March, six months earlier (and it actually ended in November of the same year).

Market indicators – such as the shape of the yield curve, credit spreads and equity market performance – can be used as potential leading indicators of a recession, but they often give false signals. Early 2016 was a great example of such a false signal.

Our current estimation is that there is a 25% probability of a US recession in the next 12 months. While this is clearly not a central scenario, it is still a possibility that investors should take into account when making investments. So while we prefer equities over bonds, we believe investors should still have bonds and cash in their portfolios to help reduce the downside risks should a recession unexpectedly occur.

Based on your dealings with investors and clients, how is the mood like among investors? Is it euphoria, caution or a great urgency to look for yield?

This is actually one of the most unloved equity bull markets I have experienced. Most of our clients remain underweight equities. To the extent they hold equities, this is often within a multi-asset income approach which focuses on bonds, high dividend equities and other “non-core” income generating assets. Therefore, I believe the biggest risk to markets is a spike in inflation as this could lead to more aggressive monetary policy tightening and could hurt multi-asset income strategies the hardest. This outcome is not a central scenario, but we have been arguing that investors should consider adding more growth-focused equity allocations to supplement their multi-asset income.

What is it that investors want to buy now?

Bonds. Whenever we ask our clients which asset class they think will outperform, they say equities, but then keep investing in bonds. It is one of the reasons we still believe equity markets have some time before the bull market will end.

What are the indicators that you look at, in guiding your investment decisions? What do these indicators tell you? (An example of an indicator could be something like: Budget deficits are good for equity markets, the LEI).

Inflation is key to me in this environment of low interest rates and yields. As long as it remains low, we can remain in either a positive environment for both bonds and equities. However, once it starts rising, this will shift the central bank focus to controlling inflation rather than supporting growth. This would clearly be a headwind for bonds and could be for equities should people become concerned about a sharp rise in inflation.

Do you feel that the impact of the Fed raising interest rates have been factored into the market?

We expect the Fed to hike rates gradually, albeit at a faster pace than markets currently expect. This is likely to exert a modest upward pressure on bond yields, but as long as growth holds up, it should not get in the way of further equity market appreciation.

With the Fed raising rates, do you foresee the US dollar further strengthening?

No. We believe real interest rate differentials are more important than nominal interest rate differentials and this is why the US dollar has weakened so far this year, because real differentials have actually narrowed despite the Fed hiking. Looking forward, we do see a compelling reason for real interest-rate differentials to reverse dramatically this year.

Should the US dollar remain strong, where would you put your money?

Our view on the US dollar, that it will not strengthen significantly, is a key reason why we have become more constructive on emerging market assets in general. Our top three areas with bonds are emerging market government bonds (both US dollar and local currency) and Asian corporate bonds (particularly investment grade bonds). Within equities, we also have a preference for Asia ex-Japan equities (alongside the eurozone).

What are the main trends or changes you foresee happening in the economy over the next one-two years and how is that affecting what you are investing in?

We have to acknowledge that we are in the late stage of the US economic cycle. We will be alert to any signs that it is coming to an end as this would dramatically change our investment preferences.

What are some of the technological changes that are presently happening, which you think may change the way the sector will eventually operate (eg: autonomous driving, electric cars, ride sharing, payment systems)?

Robotics is one of the most interesting areas to keep an eye on to see how it will change the global landscape from macroeconomic, business, social, political and geopolitical perspectives. There are some very smart people arguing that, for the first time in history, this technological shift will destroy more jobs than it creates. The future is very uncertain, but it seems clear this will have a profound impact on the world as we know it. Gaining an understanding of how this is likely to evolve over time is going to be key to investors on a five-ten year perspective.

What are some of the events or challenges that we need to look out for (that are signs that the market may not be in such a great shape)?

The geopolitical environment remains a concern for me. The big picture is we are shifting from Pax Americana to a more multi-polar world where there is no clear global leader. This increases the risks of geo-political accidents. This process was already under way, but we believe that the recent election in the US and policies being pursued will merely accelerate this transition with unpredictable consequences.

It is another reason to try to have diversified portfolios to try to manage potential market volatility.