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This article first appeared in Personal Wealth, The Edge Malaysia Weekly on March 5, 2018 - March 11, 2018

The rosy forecasts of a strong global environment, rich equity market valuations and abundant liquidity could lead to more turbulence in the financial markets this year. This was seen recently when investor sentiment rocked bourses around the world, says Robert Rountree, global strategist at Eastspring Investments (Singapore) Ltd.

According to him, there are concerns that the “Goldilocks” drivers of 2017 may be a mirage that could lead to higher volatility as investors test the reality and boundaries of their good fortunes in the market thus far. “For most financial assets, 2017 was a year on steroids with solid growth, ample liquidity and benign inflation — a combination that more than offset any rise in US interest rates. These conditions look poised to extend into 2018. But it is such good news that many investors seem reluctant to accept it at face value,” he says.  

“One reason for the reluctance seems to be the remarkable uniformity among investors as to 2018’s drivers, which are good ongoing growth, rising profits and ample liquidity, despite rising US interest rates and — in spite of recent jitters — still relatively benign inflation forecasts that rank highly on most outlooks. Herein lies the problem.”

As a result of the encouraging outlooks, investors have been actively searching for potential torpedoes that will “stress test” the boundaries of various asset classes and markets. One example is the reaction to the surge in US hourly wage rates in January. When wages rose 3%, investors feared that inflation would emerge, and this led to market destabilisation and falling stock prices.

Rountree says the cause of the rise hardly suggests runaway inflation, yet investors chose to interpret it as a harbinger of surging inflation. “No one denies that inflationary pressures are rising. But to quote rising US hourly wage rates, which only rose because the numbers of hours worked fell, provides more of an insight into today’s investor psychology than it does the path of future inflation,” he adds.

Nevertheless, the case for overweighting equities remains strong this year. After a stellar 2017 earnings cycle, there are grounds for believing that the 2018 cycle could be even better, says Rountree. Many indices of the Institute for Supply Management (ISM), for example, are strongly rising, outstripping the higher forecasts of this year’s profits. There will likely be a continued shift of capital into equity markets as concerns grow over rising bond yields.

At the beginning of last year, there were plenty of deep values, especially within emerging markets and cyclical sectors. Today, however, deep values are difficult to spot, says Rountree. “Yet, many Asian and emerging market equities still lie comfortably within the ‘fair value’ range, based on consensus earnings forecasts. US equities remain outrageously valued by whatever measure one chooses, but they could remain so. The eurozone seems on track for a good economic rebound, but the high valuations suggest that the recovery has been discounted in good measure,” he adds.

“Under these conditions, it seems that liquidity is the factor to be primarily focused on this year. Although this should continue to rise even as central banks start to unwind past quantitative easing, the pace of growth will likely slow, which could trigger more volatility as investors search for value.”

 

Investing in a higher volatility landscape

Higher financial market volatility is expected this year due to slowing liquidity growth and investors’ reaction to the dynamics of this year’s policy reversal. This could provide some attractive opportunities for income investors, says Rountree.

“With higher volatility expected, investing in low-volatility equity products is one course of action. High-dividend equities — especially in Asia-Pacific — also look attractive, although the appeal may be dented by rising US interest rates. Asian and emerging market equities also look attractive to fair value,” he adds.  

Meanwhile, Ooi Boon Peng, chief investment officer for fixed income at Eastspring Investments (Singapore), says investors should consider having a higher proportion of their assets in fixed income to provide stability to their portfolios this year. With monetary policy normalisation underway, rates have already risen in anticipation of higher interest rates, leading to investors having attractive returns prospects in the fixed income market.

Apart from laying out specific plans to gradually reduce its balance sheet, the US Federal Reserve raised interest rates thrice last year, pushing the shorter-dated benchmark yields higher. Last year also marked the first time in a decade that the Bank of England hiked rates while the European Central Bank announced a tapering of its asset purchase programme, which may herald monetary policy tightening this year.

“Rate increases are clearly on every investor’s mind at this juncture, particularly following the rather sharp increases in longer-maturity US Treasury rates so far this year. We have been on the lookout for rates to increase in 2018 as the Fed normalises monetary policy further, but we are mindful that sharper-than-expected increases may adversely affect the performance of fixed-income instruments,” says Ooi.

To diversify and prepare for the higher volatility expected this year, investors should explore ways to further diversify their portfolios. One approach is using absolute-return strategies, which aim to create returns in rising or falling markets.

Unconstrained by traditional benchmark indices, absolute-return strategies have more flexibility to adjust to changing market conditions and emerging risks, making them attractive choices for diversification, says Chen Fan Fai, Eastspring Investments Bhd’s Asia-Pacific head of investments for retail and institutional business. “Absolute-return strategies refer to investment strategies that target a return above zero. And in many cases, above a positive hurdle rate such as Libor or fixed deposit rate. The hurdle rate is a numerical value used as a target to be beaten by a portfolio manager,” he adds.

Although the returns are supposed to remain positive under all market conditions and cycles with lower correlation to the overall market, not all absolute-return funds have been able to consistently provide positive returns irrespective of the market conditions. Therefore, it is critical for investors to understand the nature of the strategy and have proper expectations of how the strategy may perform, says Chen.

These issues and strategies will be discussed in greater detail at the Eastspring Public Symposium 2018, which will be held on March 10 at the Connexion Conference & Event Centre in Bangsar South, Kuala Lumpur.

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