Cover Story: What synchronised rate hikes mean for investors

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on April 9, 2018 - April 15, 2018.
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Investors must exercise caution in the medium term (the next two to three years) in this global environment of synchronised rising interest rates. However, they stand to reap the benefits in the short term with assets such as equities.

Major central banks are starting to raise interest rates in a synchronised fashion this year, which could signal the end of an era of cheap money in the financial markets. The US Federal Reserve is expected to hike rates four times this year and the Bank of England (BoE) could follow suit as the UK faces inflationary pressures due to Brexit. Meanwhile, the European Central Bank (ECB) and Bank of Japan (BoJ) are scaling back their bond-buying programme.

In Asia, the People’s Bank of China raised its deposit rates twice last year, following closely in the footsteps of the Fed. The PBoC could hike rates further this year if the inflation rate hits its target.

Central banks in emerging markets, especially those in Asia, are expected to increase rates too. “Malaysia is a good example. Bank Negara Malaysia hiked the overnight policy rate by 0.25% in January on the back of economic growth. We expect the central bank to raise the OPR by another 0.25%. We also expect countries such as Vietnam and Indonesia to do the same,” says Vaibhav Sahgal, a consultant at the Economist Intelligence Unit (EIU).

Sahgal says the synchronised rate hikes and monetary policy tightening make this year different from the last. “The major difference is how broadly the monetary tightening policy is occurring across the globe.”

While this bodes well for investors in the short term, he cautions them — especially those in the emerging markets who have substantial exposure to the stocks and bonds in their own country — to be very careful of their investments in the medium term.

Sahgal points to the EIU’s forecast of a US recession in early 2020, which could cause global funds to pull out from emerging markets. This, in turn, may cause stock and bond markets to plunge.

How will this happen? The EIU forecasts that the US economy will continue to expand over the next two years, with the unemployment rate remaining low while wages and inflation rise gradually.

Sahgal says this is because there is still room for the US labour market to tighten further. One of the reasons is that businesses in the country are also replacing human labour with machines and robots in their day-to-day operations. This has helped keep labour costs low. “That is why US inflation will take longer to build up,” he adds.

Even at the current rate of employment, Sahgal sees pockets of slack in the labour market that have yet to be absorbed, despite years of strong jobs growth. In 2018/19, when the Fed funds rate moves up, the real GDP growth of the US will be in the 2% to 2.5% range year on year.

“After capacity constraints emerge in 2019, inflation will accelerate, pushing the Fed to signal a faster pace of interest rate hikes. This pace will be greater than the economy can bear, so we expect private consumption and investments to contract for two quarters in 2020,” he says.

“Our core forecast is that the dip will be shallow and the rebound relatively rapid, owing to the Fed cutting the interest rates aggressively in response. The US will grow by 0.8% in 2020 as a whole.”

Sahgal expects US wage growth to surge after another two years of economic expansion. As a result, the inflation rate is expected to spike in 2020. “This will prompt the Fed to hike interest rates aggressively if the inflation rate climbs above 3% that year.”

He also expects the ECB to end its quantitative easing (QE) programme in early 2019 on the back of stronger economic growth. In addition, the BoJ could start tightening its monetary policy in the second quarter of that year.

Some emerging markets, including Malaysia, would have increased their interest rates by then. “This would mean less liquidity in the market and a more expensive borrowing rate. Businesses will find it harder to service their debts. Private consumption and investment will be dampened,” says Sahgal.

As global growth drops and sentiment turns sour, risk assets such as emerging-market stocks and bonds could plunge as global funds seek defensive investments in developed markets and safe havens such as gold. Currencies will also see a lot of volatility. “This is a medium-term risk emerging-market investors have to be extremely cautious of,” says Sahgal.

He explains that stock markets have proven to be highly sensitive to speculation over monetary policy, owing to the uncertainty over how much of a long bull run, seen in recent years, is due to quantitative easing in much of the developed world. “Although company earnings have risen, which augurs well for stock price increases, this in no small part is attributable to the ultra-low interest rates available. The true impact of QE on company valuations will become known over the next two years as the Fed gradually unwinds its QE programme and tightens monetary policy,” he says.

“There is a risk that share prices will crash in the US and lead to a contagion around the world. An example of this sensitivity came in early February when US data on employment, which showed an acceleration in wage growth, triggered significant volatility in global share prices amid fears of a quicker-than-anticipated tightening cycle by the Fed.”

The EIU projects that the global economy will grow at 3% in 2018 and 2019. In 2020, global growth is expected to slow to 2.4% before rebounding to 2.8% in 2021/22.


Rate hikes happening gradually

In the short term, at least until the end of this year, interest rates are expected to slowly rise on the back of stronger global economic expansion, says Sahgal. “This gradual increase in interest rates will not crimp growth. We are positive on the global economic outlook for the next two years.”

Other experts agree. Maggie Wong, senior portfolio manager for fixed income at Affin Hwang Asset Management Bhd, expects the Fed to be the only G3 central bank to raise interest rates this year. But there is a possibility that the BoE could hike rates in May due to the higher inflation rate caused by a weaker pound sterling, she notes. “However, there are many uncertainties going forward as the trade deals between the UK and EU have not been concluded yet.”

Wong says the ECB and BoJ have seen improvements in GDP growth and inflation numbers, but they are still not high enough to warrant a rate hike this year. However, the PBoC may raise rates as it was reported in February that China’s consumer price index had grown 2.9% y-o-y — just 0.1% from its official target rate of 3%.

Nevertheless, the impact of a rate hike will be limited as the central bank has actively managed liquidity, she says. “When the interest rate goes up, the PBoC may pump more liquidity into the market via other means such as issuing more short and medium-term loans.”

Kevin Smith, founder and CEO of US-based asset management firm Crescat Capital, also expects the Fed to be the only major central bank to increase rates.

“The Fed has been trying to lead a global synchronised rate hike, but the other major central banks have yet to follow. The EU looks closer than Japan when it comes to ending QE, but neither has begun to taper,” says Smith.

“While it is true that the PBoC lending rate has risen in the past year, it has been totally disingenuous in our view because China has had the most aggressive QE on the planet, with more than half a trillion US dollars of domestic QE in the last year. China’s QE has been growing, not tapering.”

Mohd Redza Abdul Rahman, head of research at MIDF Research, has a similar view. “A future rate hike will only be likely in the US and the UK. The EU is battling political instability while Japan’s inflation rate is still hovering below its 2% target,” he says.

Funds are flowing into risk assets and cyclical sectors as market players believe the global economy remains intact and a gradual interest rate hike will not derail global growth. Robert Rountree, global strategist at Eastspring Investments (Singapore) Ltd, says cyclical sectors such as financial, basic material and energy are experiencing fund inflows.

“We have seen a good rally in these sectors. About 18 months ago, the prices of companies in these sectors were 20% to 30% below their long-term average,” he adds.

David Ng, deputy managing director and chief investment officer at Affin Hwang Asset Management, concurs. He says global funds are still flowing into regions where economic growth and corporate earnings are high, which is why Asia-Pacific ex-Japan has been seeing inflows since last year.

“We saw this happening in 2017. And it is expected to continue this year as corporate earnings are accelerating in the region,” he adds.

Emerging-market currencies are expected to strengthen against the US dollar this year as more funds flow into the region, which makes investing in the region more appealing.

Global funds will continue to flow into emerging markets this year, especially within the equity space, says Sat Duhra, fund manager of the Janus Henderson Asian Dividend Income Fund.

The foreign reserves of many Asian countries are also at a record high, says Duhra. “The foreign exchange reserves are high not only in China but also in India, Thailand, Taiwan and other countries. This is another reason we are not negative on the impact of a US rate hike on Asia. These countries will be more protected than during the taper tantrum in 2013.”


Key risks to growth

Inflation and trade war are the key risks to the global economy, say fund managers. Ooi Boon Peng, chief investment officer for fixed income at Eastspring Investments (Singapore), is concerned that the Phillips curve may happen in the US market.

In essence, the theory says that when the labour market tightens to an extent, there will be a steep increase in wages that will cause the inflation rate to surge. “This will catch the market by surprise,” he says.

The next key risk is a trade war. At The Edge-Citigold Wealth Forum 2018 held recently, Steven Moeller said the risk of a trade war is now higher than that of a conflict between the US and North Korea. Moeller, managing director and head of multi-asset platform strategy for Asia-Pacific at BlackRock in Hong Kong, said, “We were thinking about the US-North Korea conflict in January instead of a trade war. But this has reversed in the last two months.”

Ng says this is one of the reasons investors have been more cautious on technology stocks. The firm, meanwhile, has been taking steps so it is not adversely impacted by a trade war.

“We have been deploying some cash to countries and sectors that will be less impacted by such an event. Thailand is a market we like. As for sectors, domestic consumer themes also fit the bill. We have also reduced our exposure to tech companies that will be impacted if Trump imposes tariffs on the export of US tech products to China,” says Ng.



Investment strategies in the equity space

Fund managers who are anticipating global economic growth this year would prefer cyclical stocks. Sat Duhra, fund manager of the Janus Henderson Asian Dividend Income Fund, favours cyclical dividend-yielding stocks in the basic material and commodity sectors. They include mining companies in Australia and energy companies in Southeast Asia.

“We look at companies in cyclical sectors with high yields. Some may not be paying such a high yield today, but their earnings are growing and the [dividend] payout ratio is increasing. Some investors have been withdrawing funds from the tech sector to put in basic materials and energy,” says Duhra.

He adds that defensive sectors such as telecommunications, utilities and real estate investment trusts (REITs) may not be a good choice for investors at a time when the global economy is expanding and interest rates are rising.

David Ng, deputy managing director and chief investment officer at Affin Hwang Asset Management Bhd, says the firm is taking positions in cyclical sectors that are expected to benefit from global economic growth. “We like dividend growth stocks, not so much dividend income ones. We have reduced our exposure to pure dividend stocks such as REITs. These are companies that pay dividends, but their growth is not as strong [right now]. We like companies that pay good dividends and also have strong growth going forward.”

Like Duhra, Ng favours cyclical sectors such as energy and financial. He says the fund house has a big position in China and Hong Kong banking stocks. The stocks are undervalued as investors have been sceptical about the numbers provided by Chinese banks and the government. They have also been worried about China’s economy, which has a very high level of government and corporate debt.

“Everyone was sceptical. The price-to-book ratio was 0.6 to 0.7 times when we bought into these stocks. But things have turned more positive as the Chinese government’s supply-side reforms are working. The banks’ non-performing loans (NPLs) are reducing, albeit gradually, and asset quality has improved,” says Ng.

In Malaysia, he favours banking stocks and large-cap oil and gas counters. “This is on the back of the oil price recovery. We like big names such as Petronas Chemicals Group Bhd, Petronas Dagangan Bhd and Dialog Group Bhd.”

Robert Rountree, global strategist at Eastspring Investments (Singapore) Ltd, sees opportunities in cyclical sectors in Asia-Pacific ex-Japan, except the technology sector. He says sectors such as financial, infrastructure and basic materials are still undervalued and their share prices have room to run.

“The markets have been chasing growth momentum stocks [such as tech stocks] and the value investment style has been out of favour for a long time. There may be a switch from momentum to value investing going forward,” says Rountree.

Being a market bear, Kevin Smith, founder and CEO of Crescat Capital, says he finds value in the long side of precious metals and precious metal mining companies. “We still like US tech stocks, particularly in the cybersecurity space. But we are holding them.”

Smith is also taking a short position in the equities of the US, China, Australia and Canada. “We think the bear market has just begun, with the synchronised global equity mini-crash in February,” he says.



A bearish view of the markets

While economists and fund managers are positive on the global economy this year, Crescat Capital founder and CEO Kevin Smith does not think so. He says the US Federal Reserve could be raising interest rates too late in the economic cycle.

The country’s low inflation rate, after nine years of economic expansion, shows that asset bubbles have formed without an improvement in the country’s economy. An interest rate hike could burst these bubbles.

“The Fed knows there are asset bubbles in the US and around the world across a variety of assets, including equities, real estate and credit. It has been trying to let the air out slowly. It is also trying to get ahead of rising inflation,” says Smith.

“However, the US is not seeing as much inflation as we would expect at full employment today, after almost nine full years of economic expansion, which is the second longest in history. So, the question is, is it already too late in the economic cycle for the Fed to raise rates further? Could it cause more harm than good at this stage? Rather than letting the air out, could it only lead to a bursting of global asset bubbles?”

Crescat offers the Crescat Global Macro Fund, which won the HedgeFund Intelligence Absolute Return Award in 2015. It was also named one of the top 10 macro hedge funds by Preqin (which provides data to the alternative assets industry) and BarclayHedge in 2014. Under Smith, the fund has been taking a short position in the US stock markets since last year.

While some fund managers believe that the Fed is now ahead of the curve by raising interest rates at a pace faster than the inflation rate suggests, Smith does not think so. “The Fed tends to hike rates too late in the economic cycle when the asset bubbles have already got too big. It is their lack of hikes earlier that allowed the bubbles to get out of control in the first place,” he says.

Smith is also bearish on the Chinese economy. He says the country is at an extremely late stage of its economic cycle. Its credit bubble, which is the “biggest macro bubble in recorded economic history”, will burst.

“China has contributed more than 50% to the world’s GDP growth in the last decade. A burst credit bubble could impact economies that have large trade and capital flows linked to it,” says Smith.

He adds that these countries include Hong Kong, Singapore, Canada, Australia and several Southeast Asian countries such as Malaysia.

All in all, he says central banks and corporates are now sitting on “the largest coordinated global debt bubble the world has ever seen” based on the global debt-to-income ratio. This would lead to the next major downturn in the global economy.

“There is insufficient income to service the debt. This problem has been ongoing for too long already, aided and abetted by central banks. The problem is particularly acute in China, where debt can only be serviced with new and larger debt,” says Smith.

“In our view, global equity, credit and real estate markets are headed for a major downturn that will feed on itself as global asset bubbles implode and investors scramble for safe-haven assets. This, in turn, will lead to the next global recession. February was only the beginning of what that downturn will look like in the global equity markets.”

He says the market recovery so far is “nothing more than a bull trap”. His bearish view on the US stock markets is reflected in Crescat’s 3Q2017 letter published on its website.

In the letter, it says US stock prices are at historical highs and are overvalued. For instance, the large-cap stocks are overvalued when it comes to their price-to-sales, price-to-book, enterprise value-to-sales, enterprise value-to-Ebitda, price-earnings and enterprise value-to-free cash flow ratios.

The firm believes that the US stock markets will crash sooner or later. It also says China has the “biggest credit bubble of any country in history” and is poised to burst.