High valuations can be sustained
Standard Chartered Bank strategist sees Asia ex-Japan equities offering value
THE year 2017 surprised on the upside and was a great one for investors. Global equities rallied over 20%, while commodities, bonds and alternative strategies generated positive returns.
So, what about the outlook for 2018?
Investors are understandably concerned about high valuations in both equity and bond markets.
Manpreet Singh Gill, head of fixed income, currencies & commodities investment strategy Standard Chartered Bank gives StarBizWeek his view on why he is still positive on equities, and how investors can position themselves in an increasingly elevated market.
Do you think these high valuations can be sustained this year?
Yes, we believe they can and may possibly rise further. The US market is a great example of why we hold this view. For one, the rise in valuations has been followed by a strong rise in earnings, season after season. Historical data also show there is good reason to expect reasonably solid returns from current valuation levels. Both these factors are cause for optimism, not worry, about investment returns in the coming year.
In our opinion, Asia ex-Japan equities offer value as well. Again, while valuations may look somewhat elevated relative to their own history, they remain barely off cyclical lows when you compare them against developed markets. We believe the rise in valuations can be sustained this year and may have room to rise further.
The only part of the market where valuations concern us are parts of the global high yield corporate bond market. Unlike equities, valuations are now much closer to the peaks achieved in 2007. While this by itself does not mean a pullback is imminent, it does lead us to believe that there are better places to look for value.
Should investors move towards higher yielding assets or still position for growth assets?
We believe positioning for growth assets makes sense at this point. Growth assets tend to outperform income-oriented assets late in the cycle. This view also fits well into our scenario-based way of looking at the world – income assets did very well over the last few years (except for 2017) as growth continued to muddle through and central banks kept the liquidity taps wide open.
However, less accommodative central banks mean that while income assets may still do well in absolute terms, growth assets are now more likely to outperform. From a multi-asset investor’s point of view, 2017 was the first year that a more balanced approach – one that had a more growth-oriented tilt by its blend of equities and bonds – outperformed a multi-asset income approach.
While an income-oriented approach may still make sense for income-seeking investors – we still believe absolute returns should be reasonable – total return investors are probably best served by focusing on growth assets for now.
What are your core themes and beliefs for 2018?
One of our core beliefs is that it is both a blessing and a curse to be fairly late in what has already been a very long business cycle as equity markets tend to deliver some of their best returns late in the cycle.
However, it also means we are that much closer to the end of the cycle, which is always difficult to time. Unsurprisingly, the business cycle sits at the heart of our thought process at the start of 2018. We believe we still have some solid investment returns ahead of us, hence equities remain our most preferred asset class (especially those in Asia ex-japan and the eurozone).
We also believe inflation is worth watching very closely, particularly in the US, because of how much it could surprise us in a good or bad way. An extended period of modest inflation is great for equities and corporate bonds because it means central banks don’t need to step on the brakes.
However, a rapid acceleration in inflation could spell trouble for most investment markets. While this isn’t part of our base-case scenario, it isn’t something we can ignore.
As the market is now very high, there is a risk that more drops will take place. How are your clients feeling? Are they anticipating a drop, or is there a growing confidence among them?
Conversations about the possibility of a correction in equities and corporate bonds markets have indeed become more frequent, especially at our own investment committee. However, we believe staying invested is a far more important decision at this point in time than trying to excessively time a pullback, for two reasons.
First, most indicators of shortterm pullbacks are not flashing red at this time. Select technical indicators do show that the market rally may have become somewhat stretched. However, fund manager surveys show that cash holdings on the sidelines are already somewhat higher than usual and upward market momentum is very strong.
Overall, this is not a checklist that points to an imminent correction.
Second, any pullback could come from much higher levels, and may be too short-lived or shallow to time. That has been the lesson from most corrections over the past few years.
How do you advise your clients when they ask you what sort of assets/stocks they should hold on to, to protect against sharp drops in the market.
One piece of advice to keep in mind is that not all “safe” assets offer insurance-like behaviour against all possible risks. Therefore, the basics of diversification is often the very first, and the most powerful, line of defence against the risk of a bad outcome in markets.
Within this context, though, we do think a few asset classes look interesting from a more defensive point of view. A small allocation to gold, for example, can help offer some protection against either an escalation of geopolitical risks or a surprise rise in inflation.
High quality bonds have traditionally been one way of reducing volatility during times of uncertainty. Finally, a basket of alterna- tive strategies can help offer exposure to our preferred asset classes, but in a way that better manages downside risk.
You are of the opinion that during a maturing bull market, equities tend to do very well. So what sort of equities should investors look into? Is it the big and established players for example?
We have examined opportunities in small and mid-cap equities from time to time, especially in the US where, at the time of Trump’s election, we felt they offered better exposure to potential tax reforms.
However, small and mid-cap equity valuations today look far more stretched than mainstream, large-cap equities in most regions. Late in the cycle, we also believe it makes sense to not add an unreasonable amount of risk.
Having said that, a sector approach may still offer interesting opportunities at this stage of the cycle. In the US, for example, we favour many procyclical equity sectors, like financials, which we believe can do even better than the broad market at this stage in the cycle and can benefit from rising interest rates. We also continue to like technology, a sector which has done well for us over the past year as well.
What about inflation? Do you see it rising this year? Should that happen, it would be back for equity markets right, as central banks will then attempt to cool the market by raising interest rates?
Inflation is possibly one of the most important economic indicators to watch in 2018. We tend to look at market outcomes from the perspective of possible scenarios and how inflation pans out especially in the US and Europe sits at the heart of our various scenarios.
We do believe the global economy continues to transition from what we saw as “muddle-through”, an outcome where growth was okay but inflation was low, towards one that is more reflationary.
This means that while growth is accelerating, we expect inflation to accelerate modestly alongside it. This seems reasonable when you see how low unemployment rates are in major developed countries.
We do not expect markets to worry excessively about a modest rise in inflation – policymakers have spent the better part of the post-2008 period trying to achieve a more inflationary world.
However, you can have too much of a good thing. If the rise in inflation were to get out of hand, we may begin to worry about equity and bond markets. We do not believe such an outcome is very likely, but it is a possibility we cannot ignore.
What about the US dollar? How do you see it performing this year? With that, how would you also strategise based on this view?
We expect the US dollar to continue to weaken modestly, albeit not in a straight line. Like many others in the market, we believe the Fed will raise interest rates. However, this will hardly surprise