Are the US Feds’ knives already out for slaughtering the equity market bull?
We have moved to “Overweight on China equities,” but if 10-year US Treasury real yields break towards 1.5 per cent, it may be time to review our positions.
They say bull markets do not die of old age, but are murdered by the Fed. Last week, inflation-fuelled fears of a greater-than-expected rise in interest rates gave the ageing Bull a severe mauling – particularly in the US – prompting investors to ask whether the global rally in equities was set to roll over; or whether it had the legs to continue higher.
Already the longest bull market in the US since the 1930s – extending gains for 106 months, or almost nine years – questioning the longevity of the rally is entirely reasonable, particularly given the 6 per cent surge in the S&P in January alone.
But as a general rule, what melts up must also melt down; and the correction – particularly in Asia – has been brutal, returning prices to levels last seen in October/November of 2017.
It is highly likely that the growth-inflation trade off, which is driving risk sentiment currently, is likely to continue for some time.
In anticipation of likely higher volatility, how should investors approach the market? Should we be greedy when others are fearful, as Warren Buffett advised? Or should we know when to hold ‘em or when to fold ‘em, as Kenny Rogers suggested?
The problem with such a question is that we only know that markets have corrected after the fact. If we knew price declines last week were merely temporary, buy-on-dip investors would be out in force and the market would be surging higher. Equally, if we knew the sell-off was the start of something more worrying, we would see, or hear, only tumbleweed.
It doesn’t help that markets refuse to play to a consistent or firm set of rules. If an analyst tells you a bull market cannot exist in a period of rising rates, or rising bond yields, economic recession, negative earnings, or even extreme valuations; don’t believe them.
The history of financial markets is replete with examples of both bull and bear markets thriving in the most incongruous and/or contradictory circumstances.
Of course, bull markets are more likely to roll over in the face of a combination of factors – including but not limited to, excessive euphoria, high corporate debt, widening credit spreads, loss of market breath, and extended price momentum – but none of these so-called preconditions, in my view, are flashing signs of danger just yet.
The most insightful and consistent way to explore market opportunities, as always, is to focus on the analyst’s toolbox: fundamentals, valuations and technicals. And right now, there are few signs, in my opinion, that suggest the bull market is going to come crashing down any time soon.
In fact, these are salad days for the global economy, which is expanding at its fastest rate in over 10 years. And after a long period of subpar growth, Asia too is having its moment in the sun, with regional growth likely to expand by a China-boosted 6 per cent in 2018, around the same heady pace as last year. Late cycle bull markets can falter as the probability of recession increases; but current macro momentum – both in the emerging market and the developed market – remains reasonably balanced and stable.
Indeed, corporate fundamentals are actually improving despite rising inflation expectations, delivering an expected 16-18 per cent earnings per share (EPS) growth in Asia ex-Japan in 2018 alone. Under these favourable conditions, our analysis suggests that following an 8-10 per cent correction, equity markets typically generate a further 10 per cent return over the next six months, and 20 pe cent return over the 12 months. This is precisely the returns profile that buy-on-dips investors like to hear.
Importantly for Asia, we anticipate the US dollar to remain under pressure for at least the next six months. Despite expectations for three or four interest rate increases in the coming year, the US dollar remains vulnerable to widening current account and fiscal deficits further compounded by political uncertainties - if not outright instability.
A weak US dollar usually ensures global liquidity becomes more adventurous, seeking growth and earnings opportunities in the emerging markets in general, and Asia in particular. In other words, it’s supportive for Asian equities.
Within Asia, our latest stand-out call remains our “Overweight on China equities”, with the buy catalyst being the dizzying 13 per cent decline in the price of the Hang Seng China Enterprises Index (HSCEI) since its highs in late January – a fall we consider largely overdone.
What are the risks to my reasonably sanguine view? And what should we be looking at for early signs the market may experience pressure?
Well, it seems that driving macro risk appetite is not the usual VIX Index – the so-called fear index – but rather 10-year US yields; or more accurately the 10-year US real yield, adjusted for inflation.
Currently this indicator is trending towards the upper ranges of 0.8-0.9 per cent posted over the past five years, but has yet to break through in any meaningful way.
To the extent that I believe existing inflation risks have been largely priced in following the sharp spike in yields over the past few months, I am comfortable with the existing range holding.
However, caution may be required if real yields start breaking higher – perhaps towards the 1.5 per cent area – which could be negative for equities, and would prompt a review of our positions. One to watch.
John Woods is the Chief Investment Officer, Asia-Pacific, at Credit Suisse.
