Investing: ‘Diversify into bonds to prepare for downturn’


  • McDonnell: Now that the low oil price has run its course, we may see a write-back and they may start to bring the machines and infrastructure back on stream to produce oil. We will see energy earnings rise from here and this will contribute to their financial results for the first quarter of next year.Photo by Suhaimi Yusuf
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This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on September 5 - 11, 2016.

 

Investors who are heavily invested in equities should begin diversifying into bonds as the global economy is moving towards the end of the cycle, says Clive McDonnell, head of equity investment strategy at Standard Chartered Bank.

Diversifying into bonds can provide investors with stable income and better risk-adjusted returns, he adds. “We are cautious about equities and are more positive on US investment-grade bonds and emerging market US dollar-denominated bonds. Investors should have an ‘insurance plan’ before the global economy falls into a recession. This can be done by allocating more of their investments to bonds.”

McDonnell says the Malaysian bond market will benefit from the oil price stabilisation and foreign inflows into Asian markets. Meanwhile, crude palm oil production is expected to recover with the arrival of the La Niña phenomenon, which will see more rainfall.

All these factors will provide further upside for the ringgit and make the local bond market more attractive to foreign investors. “We have seen the ringgit recover from its lows. We are not bullish about it, but there is potential upside,” says McDonnell, who is based in Singapore.

He points out that Malaysia’s bond yields of 3% to 4%, while lower than Indonesia’s at about 7%, are still higher than those of other Asian countries such as South Korea, Taiwan, Hong Kong and Singapore.

Standard Chartered says in its 2H2016 Global Market Outlook report that it favours US investment-grade corporate bonds because they currently provide investors with a yield of about 3%. More importantly, the bonds could function as a safe haven when market volatility rises globally.

“The yield premium on US investment-grade corporate bonds has been compressed since the start of the year. However, they still offer a yield of close to 3%, which we view as attractive in today’s low-yield environment,” says the report.

“Valuations are marginally expensive ... but we believe the search for yield and demand for defensive and less volatile high-quality bonds could drive valuations further into expensive territory. Brexit has merely reinforced this bias.”

Standard Chartered prefers emerging market US dollar-denominated bonds over local currency bonds due to concerns about Asian currency risks, which will impact the returns of international investors. This is despite the attractive returns Asian emerging market bonds have provided year to date.

According to the report, the bonds of Southeast Asian countries such as Indonesia, the Philippines and Malaysia have provided returns of about 11%, 7% and 6% respectively (as at

June 27). China and Hong Kong bonds have seen returns of about 5% while Singapore and South Korea bonds have generated returns of about 4%.

McDonnell says there are already signs pointing to an imminent global recession. “Take the US stock market. We saw low volatility in 2014 and it has been trending up with higher spikes over the years. Corporate earnings have contracted for four consecutive years. Interest rates are another classic signal of economic cycle and central banks globally are cutting rates.”

He points out that an economic cycle lasts for seven years on average and the global economy last saw a financial crisis more than seven years ago in 2008. “This is one very straightforward measurement of an economic cycle. An economic cycle lasts five to nine years historically. The average is seven. And it has now been 7½ years since the last global financial crisis.”

McDonnell, who is one of the co-authors of the report, believes there are investment opportunities in the equity space amid the sluggish global economy. He says the US energy sector, mainly oil and gas companies such as ExxonMobil, Chevron Corp and Schlumberger Ltd, are expected to see a huge earnings pickup in the first quarter of next year.

“These companies have written off the value of their primary assets, in line with the plunging oil prices, which include energy reserves as well as machines and infrastructure. This resulted in huge losses in their previous financial years. These companies tend to be prudent, and even though there is still value in these assets, they have written down the value to zero,” says McDonnell.

“Now that the low oil price has run its course, we may see a write-back and they may start to bring the machines and infrastructure back on stream to produce oil. We will see energy earnings rise from here and this will contribute to their financial results for the first quarter of next year.”

He says the earnings per share of US energy companies are expected to rise 12%. “We will be buyers on that now, definitely. Then, after the rebound, we will probably sell down a bit and drift lower back, depending on our outlook for oil prices.”

McDonnell says the stabilisation of oil prices has benefited the US energy sector. They are expected to range from US$45 to US$55 per barrel this year.

“While US oil inventories peaked in April at 450 million barrels, they have since declined to 420 million barrels. So far, this has not acted as a catalyst for oil prices as the inventories of some refined products have risen, pushing refineries to slow down purchases. However, we expect the focus to return to the decline in inventories and lower US shale output to push up oil prices,” he says.

Brent crude oil prices have been hovering between US$40 and US$52 a barrel since April, having recovered from a low of US$28 a barrel in January.

 

Opportunities in emerging markets

McDonnell says Asian emerging markets will benefit from the political uncertainties in the West and global investors’ concerns over China risks. Foreign capital is expected to continue flowing into Asian markets, sending stock and bond prices up.

In fact, after the Brexit referendum, investors poured more money into Asia. This has strengthened Asian currencies and bond prices.

“We are quite surprised by the increase in inflows [into Asian markets] after Brexit. We think this is also due to the uncertainties caused by the US and EU’s forthcoming elections. Also, Asian markets are undervalued and worth looking at again. The China risks are probably overdone and not as big as previously thought,” says McDonnell.

He adds that the stabilisation of commodity prices is a boon for emerging market equities. Meanwhile, investment opportunities in commodities, such as iron ore, have started to emerge in non-Asian emerging markets such as Russia and Brazil.

“Russia is expected to benefit from the firmer oil prices while Brazil’s equity market highly depends on iron ore prices, which have bounced back from US$40 to about US$60 per ton. The economies of both countries are turning around,” says McDonnell.

According to Standard Chartered’s 2H2016 Global Market Outlook report, the Russian economy is expected to resume growth by the fourth quarter of this year after a two-year downturn due to plunging oil prices.

The report says Russia’s service sector has started to grow again, but the manufacturing sector continues to contract. Inflation has fallen from more than 16% last year to over 7% this year. Meanwhile, Brazil’s economy is expected to experience a slower contraction in the second half of this year and start growing again in the second quarter of next year.

“The new government, led by Acting President Michel Temer, has been able to get the parliament’s approval for key reform measures aimed at reviving business and investor confidence. These measures have lifted consumer confidence and led to a rebound in stocks, bonds and currency.

“However, we will watch for further measures that are needed to curb public spending, cut the fiscal deficit (currently close to 10% of GDP) and bring down inflation (currently above 9%). These measures are likely to enable the central bank to start cutting rates, currently at a 10-year high of 14.25%,” says the report.