Capital: Broker Write - Impact of rate cut reversal biggest risk to financial markets

This article first appeared in Capital, The Edge Malaysia Weekly, on December 25, 2017 - December 31, 2017.
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By Gan Eng Peng
Director of Equity Strategies & Advisory, Affin Hwang Asset Management Bhd

WITH the return of growth, 2017 has seen an economic upswing that lifted both global and regional markets in terms of asset returns and earnings recovery. Accelerating growth, but benign inflation, has kept policy tightening at bay, creating the right conditions for risk assets to perform well in a Goldilocks environment. Asia scored top marks and was one the best performers due to its trade linkage to global growth and the decent domestic environment. The MSCI Asia ex-Japan Index advanced 37.8% (local currency terms), compared to the MSCI AC World Index, which gained 19.5% year to date (as at Nov 29, 2017).

Going forward, the macro outlook looks promising with growth expected to remain robust and other global economic growth indicators revised upwards. The global growth cycle can now broaden out across sectors and countries, aided by a revival in the capex cycle. Improving business sentiment, rebound in profits and benign credit conditions are driving new business investments and will lead to a pickup in capital spending. We believe the earnings recovery in China, South Korea, Taiwan and India will continue to broaden towards Southeast Asia, which has been a laggard this year.

Asia was in a bull run in 2017 — except for Malaysia. There are many reasons for this — poor earnings growth, domestically focused listed companies as opposed to a strong export sector, looming election risks, local selling and lack of foreign interest, given the more rapid rise in large liquid markets like Hong Kong and China. Locally, we expect the strong set of GDP print to eventually trickle down and broaden in the market, as it catches up to the economic upcycle. Malaysia’s GDP continues to point towards growth led by strong exports and private consumption. With less selling pressure going into 2018 and with potentially better micro support for the GDP number, we think prospects for the FBM KLCI should be more vibrant. We are looking for total return of around 8%, with 5% to 6% from market upside based on projected earnings growth and no re-rating or derating, and the balance from dividends.

Globally, the breadth of earnings upgrade has expanded beyond tech as other sectors play catch-up after the tech rally, which has topped out temporarily. Progress in the US tax reform had initially triggered a rotation from tech sector names, as the non-tech sectors are seen to be bigger beneficiaries of the tax reform plan. Old economy sectors including energy, financials and industrials are seeing positive earnings upgrades as a synchronised economic expansion supports a recovery in these sectors. This is positive as one of the bigger concerns we had was how narrow the global and Asian rally had been. Over 40% of the Asian bull run was driven by only 10 names — mostly tech. Tencent Holdings Ltd accounted for 30% of the Hang Seng Index’s YTD gain of 31%. There was limited breadth to the rally.

2018 will also spell the reversal of a rate cut cycle, with global central banks expected to gradually lift interest rates and start putting the brakes on years of unconventional monetary policy stimulus. This clearly is the largest risk facing financial markets. How global central banks manage this gradual pull-back in liquidity without sending shockwaves through the financial system will have to be closely monitored. Years of liquidity-driven rallies with over US$10 trillion pumped into financial systems will go into reverse. There was no historical benchmark when the pumps were turned on, there is certainly no history to guide us as we reduce this unprecedented stimulus.

Another risk factor is the rise of bitcoin/cryptocurrency. With pricing moving so fast due to the influx of money, it will mathematically become bombastic in size, or the bomb. This new phenomenon might have its own impact on financial markets, given its rapid change. We just don’t know what the impact is yet.

Locally, a risk factor is the entry of Chinese contractors to make up a new layer in the construction ecosystem. This takes away the margins of existing players. The 14th general election should be a shoo-in for the incumbent government, but the run-up to it will be noisy and dirty and could affect market sentiment.

Lastly, the risk factors that drive markets down are always unknown ones and not what we already know.


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