Cover Story: investing in 2018

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on December 25, 2017 - December 31, 2017.
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The robust growth seen in the global economy this year is expected to spill over into 2018. Therefore, individuals should stay invested and maintain a risk-on mode next year as growth continues to pick up, say private wealth bankers and local fund managers.

“We have had such a friendly environment this year, and this is expected to extend into next year as the global economy is still improving. Investors have made money in various asset classes this year ... For instance, the MSCI All Country World Index is up 24% in US dollar terms this month. Bonds, which we have been more cautious about starting this year, have also generated 8% returns,” says Standard Chartered Bank Malaysia Bhd head of managed investments and product management Danny Chang.

He adds that global economic growth this year was largely supported by the US economy, which is expected to continue to expand next year, judging from the low unemployment rate, stronger corporate earnings and gradually rising salaries.

In October, the International Monetary Fund forecast that the global economy should grow 3.6% this year and 3.7% next year, compared with 3.2% in 2016. The World Bank has forecast that the global economy will grow 2.7% and 2.9% this year and next year, up from 1.7% last year.

While China has maintained its path of slower growth, the European Union (EU) has seen unemployment rates trending downwards as corporates have shown healthy earnings under the European Central Bank’s (ECB) bond-buying programme. Japan, the world’s third largest economy, has grown for a seventh consecutive quarter, the longest streak in nearly two decades.

Apex Investment Services Bhd CEO Clement Chew says, “Our central view is that this is not the time for investors to bail out of their investments. The global economy is growing above-trend. The momentum is expected to extend into the first half of next year. Maybe it will ease off a bit in the second half, but it is still a very robust environment. Our projection is that global growth in 2018 should be about 3%.”

More importantly, he says, global growth this year is well supported by strong corporate earnings, providing a solid foundation for next year’s growth. Based on the MSCI All Country World Index, corporate earnings globally this year are generally positive, a stark contrast with 2016.

“Just by looking at the world’s two largest economies — the US and China — their corporate earnings are good and analysts are revising [forecasts] upwards. This is supportive for higher share prices [globally] going forward,” Chew says.

 

US growth expected to continue next year

Despite the positive news, investors are concerned that the global economic growth cycle is close to its peak. The US economy, which is now supporting global growth, could be edging towards a downward cycle sooner than expected. This would drag down global growth and send negative sentiment across the global markets.

After all, the US economy has experienced the third longest expansion in its history, lasting for 100 months since 3Q2009.  The longest expansion period so far was from March 1991 to March 2001, which lasted for 120 months. The second longest was from February 1961 to December 1969 that lasted for 106 months.

“If the current US economic expansion continues until the second quarter of next year, it will be the second longest expansion streak in its history. If it lasts until the second quarter of 2019, it will be the longest,” says Danny.

The US stock market, meanwhile, is at its all-time high. As at Dec 14, the Dow Jones Industrial Average hit 24,585.43 points, up 24% from the beginning of the year. The Nasdaq Composite Index has appreciated 26% from the start of the year.

In response, asset management firms in the US, such as Crescat Capital, are taking a short position on US indices. In its third-quarter investor letter posted on its official website, the firm says that the valuation of the US market is at its highest, based on several financial ratios — including price-to-sales, price-to-book and price-earnings.

However, other industry players, like Apex’s Chew, differ. He says there are broad indicators showing that the US economic cycle might still have legs. He points to two commonly used indicators, the yield curve of the two-year and 10-year US treasury notes.

“To put it simply, a US recession usually happens when the yield curve flattens or becomes inverse. This has happened in the last seven recessions in the US, so this indicator works pretty well.

“It is still an upward slope for now, even though it has slightly flattened recently. The two-year note’s yield is 1.8% while the 10-year yield is 2.3%. There are still about 50 basis points in between,” Chew says.

Another indicator is the core inflation rate, which is equal to the federal funds rate minus inflation. The core inflation rate in the US rose more than 1.9% in previous recessions, he says. “It is now at negative 0.5% and I don’t see it rising to that level next year.”

US high-yield bond prices are another useful indicator. StanChart’s Danny says these usually experience a correction six to nine months before the end of their economic cycle, but this has not happened so far. “Yes, the prices have come off slightly but it is not a massive sell-off. It subsequently rebounded.”

These indicators might give investors more confidence and comfort in the US and the global economy going forward. However, Chew and Danny say investors should keep an eye on these indicators next year.

 

US tax reform could take global economy to the end of the cycle

A key event moving forward is the proposed US tax reform that aims to cut corporate tax from 35% to 21%, a significant reduction that could cause the US and global economies to heat up at a much quicker pace. This could lead to a higher-than-expected inflation rate if commodity prices trend upwards as well.

In addition, if President Donald Trump were to follow through with his plans and implement infrastructure spending, it would inject a huge amount of capital into the US economy and speed it up. More importantly, it could be a catalyst that causes the US and global economies to overheat.

“This [overheating] is a typical sign that the global economy is much nearer the end of its cycle. We are getting closer to that point. It might be a 2019 story, not next year’s. That is our view at this juncture,” says Danny.

He says another risk is that central banks of the largest economies are expected to unwind their quantitative easing programmes and embark on a rate hike cycle following in the footsteps of the US Federal Reserve. This could reduce market liquidity and cause an inflationary environment. “The Fed is now alone in unwinding its QE programme and hiking its rates. But the EU and UK are already on the verge of embarking on the same cycle. Japan might take a while longer, but certain parts of Asia are already preparing to hike rates. This includes Malaysia.”

Amid a tightening cycle,  the market’s main concern now is Europe, not China, says Danny. When the ECB starts to tighten its monetary policy, will the EU economy continue to recover? Or has it become a “drug” that the economy cannot do without?

While he says he does not have the answer, Danny remains optimistic. “The EU’s unemployment rate has started to come down. Consumer spending is beginning to go up and corporate profitability is rising. Its economy is starting to fire up.”

Meanwhile, the Chinese government has been doing well in slowing down its economy, says Danny. “The markets have already seen what the government has done. The Chinese government is tackling shadow banking and is allowing default rates to slowly go up. It means non-profitable companies and industries may not be able to refinance their loans. They are doing the right thing.”

The risk associated with China is that its government could “overdo” its tightening policy and trigger a series of defaults. This would create market volatility, which would see Asian high-yield bonds impacted the most as Chinese companies within the mining, property and other sectors issue about 40% of these bonds, says Danny.

 

‘Overweight’ on equities in a growth and reflation environment

Given the broader context, equities remain the key asset class that investors should focus on next year. Danny and Chew are “overweight” on equities.

In the case of Apex, Chew says the firm has deployed more funds into the markets this year and now has a cash level of 10%.

Danny adds, “Investors should lean towards slightly more risk-on. If you are still investing conservatively, like heavily into bonds, you should consider adding a small allocation to equities.” Danny expects a reflation environment next year, which will drive investors to place their monies in risk assets (such as growth stocks) as company earnings are expected to improve, resulting in higher stock prices.

The StanChart 2018 outlook report, released on Dec 8, has a 40% probability for the reflation scenario to play out next year. This is compared to a 35% probability for a muddle-through scenario (structurally slow growth and low inflation); 15% for the global economy being too hot (sharp growth with rising inflation); and 10% for the global economy being too cold (slower growth and lower inflation).

CIMB-Principal Asset Management chief investment officer Patrick Chang says the rotation of money will continue towards the equity markets. “For most of the next 12 months, we will continue to be positive on equities versus fixed income. As long as earnings continue to deliver, we will continue to see growth. It wouldn’t surprise me if at some point, there is some disappointment on the earnings side. There may be some corrections, but I think this is a natural occurrence in a bull market.”

UOB Asset Management Bhd CEO Lim Suet Ling agrees with Patrick. After all, global economic indicators, such as the Purchasing Managers’ Index, are showing good signs, she says.

“We are still ‘overweight’ on equity as the numbers shown by economic indicators are not slowing down. The price-earnings ratio of global equity is now around 16 times, so the earnings yield that you can get from the stock market is 6.25%. Meanwhile, the yield you would get for a two-year US bond, for example, is only 1.8%. If you are ‘overweight’ on equity, there is no doubt that you are taking a risk, but the risk-reward is skewed towards equity.”

 

Northeast Asian countries to outperform

Private wealth bankers and local fund managers favour Asia-Pacific when it comes to equities, in particular the Northeast Asian countries, such as China and South Korea.  The technology sector is a key driver in these countries and companies in the sector are expected to benefit from synchronised global growth.

“We split Asia into two markets. One is a more domestic-oriented market such as India, Indonesia, Thailand, the Philippines and Malaysia.  The other is a non-domestic-oriented markets such as China and South Korea, which are more exposed to exports.

“The latter are also countries that are strong in the technology sector. You have Alibaba Group Holding and Tencent Holdings in China and Samsung Group in South Korea. The earnings of these companies have been strong in the Asia technology sector and it is where the future growth is,” says Patrick.

Suet Ling, agrees, saying, “We are positive on China and South Korea. We are now waiting for a market pullback [as it has rallied a lot since the beginning of this year and there is more buy-in].”

She favours China’s technology sector as its economy is transitioning from an old to a new economy. The trend is more than obvious. “Banks used to be the majority of the MSCI China Index at over 40%. Today, this has shrunk to about 20% while technology is about 40%. The technology sector in China is a force to be reckoned with.”

Also on Suet Ling’s radar screen are some Chinese companies within the consumer staple, healthcare and insurance sectors, which are expected to benefit from the continued growth of the country’s middle-income group.

Affin Hwang Asset Management Bhd portfolio manager Lim Chia Wei likes South Korea’s technology sector. He is keeping a close watch on some of its “internet companies and semiconductor producers”.

He says the profits and earnings of some companies have been affected by the Chinese government’s recent ban on Chinese tour groups visiting South Korea. In addition, the Chinese boycott of South Korean products has affected sales.

The boycott and the ban were implemented because South Korea decided to host the Terminal High Altitude Area defence, a US anti-ballistic missile defence system, amid rising tension with North Korea. The Chinese government sees this as a threat to its national security, explains Chia Wei. “However, in the past weeks, we have observed that China has softened its tone. There is even talk that the travel ban will be lifted. We will see how this affects the share prices of South Korean companies.”

StanChart’s Danny says Southeast Asian countries are less attractive compared with Northeast Asia, but they are still expected to perform well in a continuing global growth environment.

Patrick is “overweight” on Indonesia next year as its markets have started to price in potential pump-priming by the government prior to the country’s 2019 general election. He favours the infrastructure and consumption sectors as the government is expected to make announcements that could spur the economy and put money back into people’s pockets.

“There were a lot of political noises in the first half of this year. Consumer consumption is weak and government infrastructure spending has been subdued. However, we think President Joko Widodo knows that he has to be more populist in order to win the next election. Thus, more announcements are expected prior to the election ... I think we are seeing nascent signs of a recovery in consumption and that will drive an improvement in the Indonesian market.”

 

Local market might perform better after election

On the local front, Apex’s Chew says the country could start to look more appealing to foreign investors next year as the valuation gaps between the local market and its regional peers have started to compress. Also, the oil price, which is currently in the range of US$50 to US$60 per barrel, is positive for the local market. “We believe the local market will look more attractive to foreign investors going forward. We need more foreign investments ... not just local institutional investments.”

The relatively subdued local market could be due to the upcoming general election, which is causing uncertainty. “Our view is that the local market will remain range-bound from now until the election is over,” says Chew.

However, he is looking for opportunities outside the local benchmark index and beyond the more traditional financial, property and commodity sectors. “There are companies outside these traditional sectors that are globally competitive and are able to tap the supply chain of the global market. They are very strong in their niches. Many of them are mid and small-cap companies, but some of them are quite large.”

SKP Resources Bhd, a plastic contract manufacturing company, is one of them, he says. “The company secured a RM2 billion contract with Dyson Ltd, a British technology company, in the middle of this year to manufacture its hairdryers. It is not easy to get such an international contract. This is a company we are looking at.”

Inter-Pacific Asset Management Sdn Bhd CEO Lim Tze Cheng favours small and mid-cap semiconductor companies that are involved in testing equipment for electrical and electronic components. He says these companies are expected to benefit from the stronger future sales of electric cars as more E&E components are needed for these cars.

“Global electric car sales are only about 1.5% this year compared with [regular] car sales. There is still room for growth going forward,” he says.

Meanwhile, Danny says investors could still look at the financial sector as the central bank is expected to raise rates next year, which could bring some surprises to banks’ earnings.

 

Bonds, gold and alternative investments

While risk assets such as equities are in favour, fund managers are “underweight” on bonds.

“I would be ‘underweight’ on bonds. The Fed is now increasing interest rates and major central banks globally are expected to start tightening their monetary policies. This is negative for bond prices. Also, if you look at the equity valuations, in general, they still look more attractive than that of bonds. Bonds are trading close to their 30-year high,” says Apex’s Chew.

UOB’s Suet Ling agrees. She says: “The global economy is expanding and the Fed is normalising interest rates. This does not bode well for bond prices. We still expect bonds to give us about 3% to 5% total return, which is less attractive than equity’s 6.25%.”

However, there are still pockets of opportunity within the bond universe, says StanChart’s Danny. Developed market high-yield bonds have performed well, starting this year, generating 8% to 10% returns, which is half that of equity. Valuations have gone up as well. “In the middle of this year, we tilted our view. The next leg is emerging market hard-currency government bonds.”

Danny says this is because global investors are still “hungry for yield” while the interest rate is only rising gradually in certain parts of the world. Also, synchronised global growth always bolsters emerging market economies.

“Some investors are worried that the Fed embarking on a rate hike cycle is not good for emerging markets. But if you look at the history, emerging market [hard-currency] government bonds did well in the last Fed rate hike cycle starting in 2003. This is because the US economy was growing, firing on all cylinders, and it bodes well for the global economy and emerging markets. We are now in that kind of environment,” he says.

Also, the US dollar is expected to weaken next year, according to the bank.

“We are moderately bearish on the US dollar next year. We think the strength of the US dollar is already aligned based on the market’s expectation of the Fed rate hike.  We believe the possibility of the Fed hiking interest rates faster than expected is remote, given the current US inflation backdrop. The modestly weaker US dollar and more attractive yield augurs well for emerging-market, hard-currency government bonds. We have a strong conviction on this,” adds Danny.

Meanwhile, gold — which is seen as a hedging tool for inflation and “insurance” against macroeconomic meltdown — does not look attractive to fund managers next year.

Danny does not see inflation picking up rapidly next year, which means gold prices might not see a strong rally going forward. However, investors should not allocate more than 5% to gold in their portfolio in case inflation picks up faster than expected, he says. “Don’t forget, there is still a 15% probability of the global economy getting too hot next year. The impact of the US tax reform on its economy remains unclear for now.”

Chew says gold prices tend to move inversely against interest rate movements and the current increasing rate environment might not hit gold prices. “I don’t see gold as exciting. It tends to do well when there are economic crises and market uncertainties [but this is not the main case for next year]. Buying it is more to prepare for unexpected events.”

Recently, new alternative asset classes, such as peer-to-peer (P2P) financing and cryptocurrency, have emerged. Should investors be looking at them?

Danny says he believes personally that P2P is definitely an asset class that will grow over the year based on the experience in developed countries. An example would be Lending Club, a company operating a P2P financing platform that is listed on the New York Stock Exchange. “I personally believe it will take off locally when the awareness is there. It is definitely an alternative investment that investors can look into.”

However, he says investors should always adhere to the basic principle of diversification and be prepared for default. “To me, P2P financing is similar to high-yield bonds. The risk of default is higher and it will certainly happen sooner or later. Investors have to be aware of the risk they are taking and be prepared for it. Also, these are start-ups, and there is a possibility that one might not work out. This is why it is important for investors to diversify their investments not only into different notes but platforms as well.”

On cryptocurrency, Danny says investors can view it as an alternative asset, like wine or watches, and take a calculated risk to invest a little money in it. “Being a value investor, I’m more comfortable investing in P2P than bitcoin. The real challenge the industry is facing now with cryptocurrencies is determining their intrinsic value.”

 

Key events in 2018

Here are events to wat ch out for that could shape financial markets across the globe next year.

 

1. US tax reform

The US tax reform is expected to cut corporate tax from 35% to 21%. This could add fuel to the growth of the US and the global economy. If President Donald Trump implements infrastructure spending as he promised, coupled with commodity prices trending higher, these could cause the global economy to overheat and push it to the end of its cycle.

 

2. Major central banks unwinding their balance sheets

This could reduce market liquidity and disrupt the market. JP Morgan head of quantitative and derivative strategy Marko Kolanovic said in October that it could “trigger a financial crisis”. The unwinding of the G4 central banks’ balance sheets would involve US$15 trillion in total. However, Apex Investment Services Bhd CEO Clement Chew says the G4 central banks’ total balance sheet will continue to increase despite the US Federal Reserve unwinding its position. “The G4 balance sheet is only expected to start turning negative in 2019.”

 

3. Tension between President Donald Trump and Kim Jong-un, the supreme leader of North Korea

Trump and Kim have been trading insults in the past few months and it appears that the tension between the two countries has increased. Recently, the US Military conducted joint training operations with South Korean forces, simulating the removal of nuclear weapons from North Korea if war breaks out. While Inter-Pacific Asset Management CEO Lim Tze Cheng sees the North Korea threat as a recurring event once every few years, he is more worried this time. “There are more uncertainties this time as Trump is more unpredictable and volatile,” he says. If war were to break out, the Korean Peninsula would be the first to bear the brunt and the impact on the economies of North and South Korea would be felt for years to come. It would certainly cause global growth to slow and send negative sentiments across global markets.

 

4. Negotiation of the North America Free Trade Agreement between the US, Mexico and Canada

As Mexico and Canada are key trading partners of the US, the outcome of the negotiations will show if the Trump administration will adopt a protectionist approach to trade policy. While the outcome of the negotiations is hard to predict, a withdrawal of the US from Nafta would cause a new round of volatility in the markets of the three countries. “The market could extrapolate a larger global trade war,” said Daniel Clifton, head of policy research at Strategas Research , to CNBC last month.  

 

5. Malaysia’s 14th general election

Anticipation of GE14 is suppressing the local market as it creates uncertainty in the market. “Our view is that the market will go nowhere before the election next year,” says UOB Asset Management Bhd CEO Lim Suet Ling. Once it is over, the market could be lifted as foreign funds start to pour in. This could be due to the relatively attractive valuations of the local market compared with its peers. “The gap between the local market and its regional peers has been suppressed this year. It has become more compelling to foreign investors,” says Apex’s Chew.