This article first appeared in The Edge Malaysia Weekly on October 2, 2017 - October 8, 2017

ON Sept 15, residents of Japan’s northernmost major island Hokkaido woke up to deafening sirens blasting from speakers as a ballistic missile launched by North Korea flew over the Japanese airspace.

The missile landed 2,000km to the east of Hokkaido in the Pacific Ocean. It was the latest in a series of provocations between the hermit kingdom and the US, following calls by the world superpower for greater economic sanctions to be imposed on the regime.

While major stock markets in Asia fell during the day, they resumed their upward trend the next day and week, without any major outflow of foreign funds. The MSCI Asia Pacific ex Japan added 1.19% between Sept 14 and 22.

Does this mean geopolitical risks are not a major factor for international investors? And as October — historically a dangerous month for capital markets — dawns, should investors be worried for their investments?

International fund managers see provocations between North Korea and the US as nothing new, and therefore, do not have a heavy bearing on global markets and economy. Real economic data would be the main drivers of the stock markets, they say.

“Emerging markets (EM) continue to enjoy a sweet spot of improving growth prospects and favourable external conditions: corporate earnings have been improving amid growing evidence of a synchronised global recovery.

“Meanwhile, a weaker dollar is boosting global cross-border liquidity and helping EM currencies. This is, in turn, putting downward pressure on inflation,” says a spokesperson of US-based asset management company Aberdeen Standard Investments.

CIMB Investment Bank Bhd sees stronger interest from foreign investors in Malaysia now compared with early on in the year, its analysts Ivy Ng Lee Fang and Michelle Chia say in a strategy note dated Sept 20.

They found that foreign funds are interested in Malaysia because of the strong economic growth in the first half. Key questions that foreign funds ask are mainly growth numbers, consumer sentiment and timing for the 14th General Elections.

“At the start of the year, foreign investors were more interested in our forex views but that has now shifted to the sustainability of the strong 1H17 GDP growth as well as better appreciation of key drivers behind the GDP.

“We sensed that foreign investors are now more comfortable with the ringgit, which has appreciated 7.3% YTD to RM4.1875/US$1,” say the analysts in the strategy note.

Another event that might be negative for EM assets is the prospect of an interest rate hike by the Federal Reserve in December, as well as its balance sheet normalisation programme. Usually, when a major central bank tightens, funds will flow to safe havens.

Markets in EM Asia closed broadly lower last Wednesday after US Federal Reserve chair Janet Yellen reaffirmed her commitment to hike interest rates. South Korea’s KOSPI was down 0.46%, Jakarta Composite Index (-0.31%), and Stock Exchange of Thailand (-0.2%).

FTSE Bursa Malaysia KLCI closed 0.3% lower, in line with its peers in the region, while the Shanghai Composite Index slipped 0.03%. Meanwhile, developed Asian markets closed higher, led by the Straits Times Index with 0.57% and Hang Seng Index (0.5%).

Nevertheless, investors do not seem to be too spooked by the prospect of a higher interest rates in the US, normalisation of the Fed’s balance sheet, and heightened geopolitical risks in Asia. There seems to be a sense of fatigue among investors when it comes to these factors.

“In the past, they’ve been right to worry. Generally, when central banks start tightening, it does affect EM. However, this time round, we’ve already had that event happen back in 2013, so the markets have got over it already,” says Rajeev de Mello, head of Asian fixed income at Schroders.

This is likely because major central bankers have been careful to talk about the normalisation of balance sheets and interest rates, according to de Mello. Those that are invested should remain confident that there will not be a big drop off in asset values, he says.

Areca Capital Sdn Bhd’s CEO Danny Wong Teck Meng says as long as the path and pace of the Fed’s rate hikes remains within expectation, foreign fund managers may be swayed by the fundamentals and attach lower risk premiums to Malaysia as an investment destination.

“Although many expect EM to be negatively impacted, funds will still flow to where growth is, and it is in this part of the world where growth can still be found.

“EM have attracted a straight month of inflows (include debt and equity). This, despite Yellen having laid out the Fed’s rate hike plans since 2015 and when the Fed first mentioned the idea of reducing the balance sheet in July,” says Wong.

In its Asian Development Outlook (ADO) 2017 Update released recently, the Asian Development Bank (ADB) forecasts the region’s gross domestic product to grow by 5.9% this year, a slight increase from 5.8% in 2016.

For Aberdeen Standard Investments, EM doing much better economically are some of the good news that will support asset prices in these economies. It has also not seen much foreign fund outflows from EM assets so far.

In Asia, China’s economic growth in the second quarter of the year remained stable at 6.9% year on year. South Korea’s exports is expected to rise for the tenth straight month in September, expanding 21.6% from a year earlier, accelerating from a 17.3% surge in August.

Malaysia’s economy has also been doing surprisingly well this year, recording a growth of 5.8% in the second quarter compared with the same quarter a year ago. The ADB says that Malaysia, alongside Hong Kong, will see the biggest jump in economic output this year.

How would Fed’s balance sheet normalisation affect investment flows?

The Fed expanded its balance sheet by buying up government bonds and mortgage-backed securities post Global Financial Crisis (GFC). Its balance sheet reached the peak of US$4.5 trillion in October 2014, and has been maintained since then.

Starting this month (October), the Fed will reduce its balance sheet by slowing the reinvestment of maturing bonds. The target is to reduce its balance sheet to US$3 trillion by the start of the next decade.

In the past, announcements by the Fed regarding normalisation of the quantitative easing and interest rates have caused funds outflow from EM to the US and other developed markets, this time round, things are much calmer on the trading floors.

“In the short term, there will be some negative knee-jerk reaction from the tightening of quantitative measures on equities, with funds to flow back into US bonds.

“Provided the proposed tax cut by the Trump administration is not implemented soon, investors and fund managers will put their money in more stable and interesting markets such as Japan and Southeast Asia,” says Rakuten Trade’s head of research, Kenny Yee.

How does the Fed’s balance sheet normalisation and rising interest rates affect the performance of an investor’s portfolio?

First, investors should expect lower returns from bonds as bond yields are likely resuming their gradual rising trend, says Dr Shane Oliver, head of investment strategy and economics and chief economist at Australia-based AMP Capital.

“Second, shares should be able to withstand the latest leg in Fed tightening just as they have since the end of quantitative easing in 2014 and the four rate hikes the Fed has undertaken since.

“Shares are still cheap relative to bonds; the Fed is only tightening because growth is strong and this means higher profits; and Fed monetary policy is a long way from being tight to the extent that it will threaten US or global growth,” says Oliver.

The world’s largest asset manager BlackRock has said that it remains overweight in EM equities in its Investment Directions Report released last month. However, investors should still be aware of the risks and remain selective.

On the bond market, de Mello from Schroders says that investors have to look for a market that gives the best yield. In Asia, Indonesia, India and China are countries which offer the highest yields for bonds, and have stable macroeconomic fundamentals.

“Indonesia is one of the countries which we favour: 7% yields for 10-year bonds, a very stable currency; low deficits including a low trade deficit. These are generally all positives for bond investors.

“China’s bonds also offer potential for investors: 3.5% yields but also the opportunity to have an offset in case there is some risk coming from China. Government bonds are usually the safe haven that investors flock to,” he says.

EU reform uncertainty

The just-concluded 19th Federal Election in Germany saw Angela Merkel winning her fourth term as the chancellor of the federal republic. However, the election result also put a right-wing party in the Bundestag for the first time since the Second World War.

The result could mean that reform of the European Union (EU) will take a longer turn for it to be materialised, says Matthias Hoppe, senior vice-president, portfolio manager at Franklin Templeton Multi-Asset Solutions.

A widely held view is that Merkel and French president Emmanuel Macron would seek to implement fiscal policies designed both to stimulate the EU economy and deepen European integration.

“However, we believe bringing about those reforms is likely to prove difficult. Merkel’s general style of government has been more reactive than proactive; she hasn’t been known for pushing hard for changes and moving them forward.

“Also, depending on who she is going to seek a coalition with, it could prove more difficult to implement reforms,” says Hoppe, adding that if the reforms were achievable, it could have substantial implications for capital inflows into equities and bonds in the region.

The areas of reform that has been talked about for the EU include the setting up of a finance ministerial post representing the bloc, as well as setting up a European Monetary Fund. A budget for the EU has also been mooted.

However, Merkel and Macron both have differences in the implementation of these reforms. For instance, while they agreed on having a budget for the EU, their views differ in terms of the size of the budget and financing.

“The re-election of Angela Merkel means business as usual to some extent, although her mandate was eroded and she will need to form a potentially messy coalition with new partners. This may lead to greater political risk within the heart of Europe.

“The success of the AfD in these elections will also give encouragement to anti-EU voices in other member states,” says the Aberdeen spokesperson, referring to Alternative for Germany, the right-wing party that secured almost 13% of the vote in the Federal Election.

While geopolitical risks are heightening in some parts of the world, it does appear that the stronger global economic recovery takes precedence in investors’ decision-making on where to allocate their money. The Fed’s interest rate hike and balance sheet normalisation have also been well communicated, minimising the impact on EM assets.

So, while keeping an eye out for any October calamity, keep calm, and hold on tight to your investments.

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