This article first appeared in Capital, The Edge Malaysia Weekly on February 5, 2018 - February 11, 2018
THE US stock market opened with a stumble last week — after closing at a record high of 26,616.71 points the preceding week — dropping 2.03% in two days. Against this backdrop, yields in 10-year US Treasury notes were on the rise — hitting four-year highs of 2.7995% last Friday.
The FBM KLCI appeared to mirror US equities, closing last Monday at a three-year high of 1,870.52 points only to lose momentum following the drop in US equities.
While the fundamental data — global and domestic gross domestic product growth — looks good, could rising bond yields in the US put a dampener on equities, or should Malaysian investors be more worried about domestic events such as the upcoming general election?
On the US-yield front, experts say there is nothing to worry about.
Rakuten Trade head of research Kenny Yee says he does not see a correction in US equities with the rising yields.
“We think that the market has already priced in the impact from higher US Treasury yields, so we don’t think there will be any correction,” he adds.
Fortress Capital Asset Management director Geoffrey Ng concurs. “The Fed (US Federal Reserve) has done a great job in sufficiently preparing the US equity markets for further rate hikes, with sentiment supported by the Trump administration’s corporate tax reforms, leading to expectations of higher corporate profitability and large offshore US dollar balances returning from corporate America.
“As long as US corporates deliver on their earnings expectations, and the higher interest rates are properly priced in, we think US markets can absorb the higher US yields,” he tells The Edge.
For the benefit of the layman, when the yield on risk-free assets (such as US Treasury notes, backed by the US government) goes up, it makes yields in other asset classes (such as equities) less attractive. Given that US Treasury notes are among the most liquid and widely traded fixed-income instruments, the impact could extend well beyond US shores and have potential implications for emerging markets such as Malaysia.
To put it simply, funds may rebalance their portfolios to include more of the “safe” US Treasuries while reducing exposure to riskier investments.
CMC Markets Singapore analyst Margaret Yang says the higher risk-free rate implied by rising Treasury yields translates into a higher required rate of return for risky assets.
“As [the] required rate of return climbs, the current value of equities, bonds and properties would be lower because their future cash flows would be worth less now when discounted back at a higher rate. The opportunity cost of investing in equities would also be higher,” she tells The Edge.
However, Yang says this could also work in favour of equities.
“On the flip side, rising 10-year yields indicate that money managers are withdrawing their capital from the Treasury market and will probably put it into equity and other asset classes, chasing higher potential return.
“From a liquidity’s point of view, this phenomenon is equity-positive,” she says.
Just like the Dow Jones Industrial Average, the S&P 500 hit a record high of 2,872.87 points on Jan 26. Year to date, the index has garnered gains of almost 6%.
It is also important to note that the Fed has yet to raise interest rates. Rates were kept unchanged in the most recent Federal Open Market Committee meeting in end-January, the last one for outgoing Fed chair Janet Yellen.
Nonetheless, the market is pricing in three rate hikes this year, and the Fed’s statement on rising inflationary pressures was enough to push bond yields higher. It was seen as a hawkish message from the Fed that some perceived as indicating a fourth rate hike was on the cards.
As for the Malaysian equities market, Fortress Capital’s Ng says from a relative valuation perspective, higher yields on US dollar-denominated assets mean greater competition with other countries for capital, thereby reducing Malaysia’s “safe haven” status that it had historically enjoyed due to its higher relative nominal yields.
“Malaysia’s offshore borrowing costs for the government and corporates will also rise with higher US yields, thereby impacting entities that have significant US dollar debt exposures,” he says.
Looking ahead, a potential boost to Malaysian equities this year could stem from the imminent 14th general election (GE14).
“GE14 will be ‘front of mind’ for the Malaysian equity market in the first half of the year and should be well supported given the country’s healthy GDP growth and improving consumer confidence,” says Ng.
So, is it still a good time to be invested in Malaysian equities?
“Equity markets in general are richly priced, so hunting for returns via benchmark indices should not be the strategy to pursue.
“Sectoral rotation such as commodities, resources and banks are in favour now, but it remains largely a stock-picking market to generate excess returns,” says Ng.
CMC’s Yang opines that against the backdrop of global economic upswing and earnings improvement, many institutions, banks and money managers remain positive about the outlook of the global equity market this year and the next.
“The US tax overhaul and infrastructure plan adds more certainty to the recovery of the US economy and lifts the inflation outlook.
“The potential headwind is a rising interest rate environment as major central banks — the Fed, European Central Bank, Bank of Japan, Bank of England — are shifting to a tightening monetary policy as inflation picks up globally.
“[The] market will eventually reach a critical equilibrium point when higher interest rates inhibit fresh money from flowing into risky assets, and liquidity starts to drain. If the federal policy rate goes above 3%, I will start to worry about that,” she says.
For now, the Fed’s overnight funds rate is anchored at 1.25% and 1.5%. The market is now expecting a 25-basis-point hike next month to keep inflation in check.
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