This article first appeared in Personal Wealth, The Edge Malaysia Weekly on February 18, 2019 - February 24, 2019

Investors will have to defend their portfolios against a slew of challenges in the market, even as the global economy continues to experience slower-than-expected growth this year, say investment experts. To ride out the tough conditions, investors will have to ensure that their portfolios are properly diversified.

According to Jai Tiwari, Citi’s regional foreign exchange strategist, economic indicators and corporate earnings revisions point to positive global economic growth. However, heavy bouts of market anxiety and tightening monetary policy may leave markets susceptible to periods of volatility and prospects of moderate returns in 2019.

“In particular, trade wars broadening or intensifying and higher US interest rates may remain prominent risks this year, generating short-term volatility but not necessarily derailing longer-term fundamentals if policy responses remain adequate. Monetary policy divergence is expected to continue as the US Federal Reserve continues to normalise rates while the European Central Bank and Bank of Japan keep policy accommodative with policy rate differentials,” says Tiwari.

The US economy’s ability to maintain solid growth is one of the key macro challenges this year, says Subash Pillai, managing director and regional head of client investment solutions for Asia-Pacific at Franklin Templeton Multi-Asset Solutions. “The US economy is facing a combination of challenges, including weaker global growth, fading fiscal stimulus, direct and indirect impact from trade disputes with China and its government shutdown.

“As inflationary pressures have eased, the Fed has become more patient when determining its path for monetary policy. How this interacts with growth headwinds will be crucial in driving market sentiment.”

In addition to the continuing trade tensions and political risks in the UK, another macro challenge that the global economy is facing is China’s deceleration, which has prompted growing stimulatory monetary policy responses in recent months. The impact of current and future stimulus will be critical for economic prospects across Asia and beyond, says Pillai.

Wenjie Lu, China investment strategist at BlackRock, concurs. In his view, the major risk in China’s capital markets this year is the excessive stimulus. A “bubbly” property market, hefty local government debts and overcapacity in the manufacturing industry have proven to be the toxic legacy of previous rounds of debt-driven stimulus, he points out.

“While we cannot completely rule out the possibility of an overreaction to domestic or external shocks, we expect the government to restrain itself from massive infrastructure spending and monetary easing. Otherwise, a key tail risk for emerging market (EM) assets is the renewal of the US dollar uptrend if the Fed tightens faster than the market anticipates,” says Lu.

“China’s current account surplus is diminishing and the interest rate differential between China and the US is much narrower than it was a year ago. Thus, capital outflow pressure looms large.”

Although excessive stimulus could be negative for China, the measures taken by its government should help lift corporate and consumption sentiment. This will lead to tactical investment opportunities in cyclical sectors, says Lu.

“Moreover, we believe the market has underestimated the structural reform potential in China. If the country’s reform history in the past four decades serves as a guidepost, its policymakers often leverage external pressure to accelerate domestic reforms and develop new growth drivers,” he adds.

Over the past few months, investors have been getting increasingly worried about the sustainability of the decade-long bull market. While Tiwari believes that global economic growth will continue, he recognises that the market is currently in a late-cycle environment.

“Citi analysts believe that the 10-year bull market is not over yet. This is a classic late-cycle bull market, when volatility tends to be higher. Citi’s Global Bear Market Checklist also provides reassurance. It is only showing 3.5 out of 18 red flags. Even at the market peak in September, there were only four red flags,” he says.

Due to the higher volatility typically observed in this environment, investors should consider adopting a global multi-asset-class allocation strategy to help preserve their investments during episodes of market stress, says Tiwari. “After cyclical peaks, global diversification has been pivotal in helping to preserve portfolio value as portfolios that are highly concentrated in particular regions, risky asset classes or both are more vulnerable to turbulence and proven to be more at risk. A global multi-asset-class allocation would produce superior returns compared with a concentrated regional allocation.”

Brighter outlook for EMs

Last year was not a good one for EMs. The Fed’s rate hikes and stronger US dollar caused markets to experience tightening financial conditions. On top of the external headwinds, the markets were further affected by fluctuating oil prices, which ultimately resulted in slower growth in the second half of the year.

Fortunately, some of the headwinds have started to recede, according to Teng Chee Wai, managing director of Affin Hwang Asset Management Bhd (AHAM). “The Fed has turned more dovish and US dollar strength is starting to top out. Fed funds futures are currently pricing in a pause in interest rate hikes this year, with a chance of rate cuts next year,” he says.

Additionally, quantitative easing measures announced by China have propped up the market. However, closer monitoring is needed to see whether such stimulus has started to trickle down to growth and GDP. This may possibly be seen around 2Q2019 due to lag effects, says Teng.

“China’s growth responds well to the creation of liquidity and we need to see credit translating into higher velocity of money and transactions that will lead to stronger growth. This could bolster fund flows back into EMs as positioning has been light with global funds underweighting EMs and there is a lot of cash on the sidelines,” he adds.

Similarly, Citi analysts expect EMs’ underperformance last year to at least partially reverse, says Tiwari. This will be underpinned by the likelihood of Asia’s growth, easing financial conditions (as moderating US growth limits the extent of interest rate hikes and US dollar strengthening) and significant easing in China, which is helping to offset most of the drag from the trade tensions.

Valuations in EMs are coming down to more attractive levels post-market selloff last year, says Teng. With the exception of the 2008 global financial crisis and 1997/98 Asian financial crisis, valuations in Asia ex-Japan today are at levels corresponding with positive market performance going forward.

However, AHAM is mindful of weaker earnings growth and further cuts to forward earnings estimates that could drag market performance. “We need to see earnings stabilise to anchor valuations forward,” says Teng.

Unlike countries with current account and budget deficits such as India, Indonesia and the Philippines, which saw significant outflows last year, Malaysia is currently enjoying a strong current account surplus due to its high export base, says Teng. “The country’s defensive nature did manage to stave off some of the selldown comparatively better than the rest of the EMs, although we did see losses across the board, with 40% of stocks on Bursa Malaysia dropping more than 30% last year.”

Malaysia’s potential fiscal slippage — which could hinder the government’s ability to reduce its fiscal deficit — has been avoided due to lower oil prices. “Based on sensitivity analysis, every US$10 change in in oil prices reduces the government’s revenue by RM3 billion, or a 0.2% increase in the fiscal deficit. In 2019, we think the fiscal position will be better than expected due to better cost management,” says Teng.

On corporate earnings, he sees growth moderating at 6% to 8% this year, with the banking sector driving most of the growth. “The market tracks earnings closely and there could be room for disappointment, especially if the banking sector comes up short. We do see opportunities to bargain-hunt, especially within the small-cap space, where we see value emerging following last year’s selldown,” he says.

These issues and strategies will be discussed in greater detail at The Edge-Citigold Wealth Forum 2019 — Ahead of the Curve, which will be held on Feb 23 at Mandarin Oriental Kuala Lumpur.

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