Lead Story: October effect?

This article first appeared in The Edge Malaysia Weekly, on October 15, 2018 - October 21, 2018.
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GLOBAL stock markets were mostly in the red last week, giving investors the jitters amid fears of the “October effect”, the belief that stocks tend to decline during this month. After all, Black Monday — the great crash of 1987, which saw the Dow Jones Industrial Average plummet 22.6% in a single day, the largest percentage drop in history — occurred on Oct 19.

The Dow Jones fell 831.83 points to close at 25,598.74 last Wednesday and extended its losses by another 545.91 points the next day to close at 25,052.83. During the week (until Thursday), the Dow fell 5.3%. Similarly, the S&P 500 Index declined 5.5% to close at 2,728.37 points last Thursday while the Nasdaq Composite Index fell 5.9% to 7,329.06.

Investors were not short of reasons to be bearish — increasingly, US corporates have raised concerns over the impact of escalating trade tensions between the US and China. It is worth noting that last week, at the International Monetary Fund and World Bank annual meeting in Bali, IMF managing director Christine Lagarde said global economic growth is “probably not enough” to withstand rising trade tensions.

The IMF has downgraded its outlook for global growth to 3.7% in 2018 and 2019, from an estimated 3.9% in July, mainly due to the US-China trade war and a slowing of emerging markets such as Brazil and Turkey. It is the first downward revision made by the IMF since July 2016.

Another issue is the coming US Federal Reserve rate hikes as the central bank continues to trim its balance sheet. Some have blamed the sharp drop in stocks on rising interest rates in the US, notably US President Donald Trump. He says the Fed is making a mistake and thinks “the Fed has gone crazy”.

Meanwhile, strong economic data and potentially higher interest rates have pushed the US Treasury yield to a fresh seven-year high of 3.23% on Oct 5, before slipping to close at 3.17% at the time of writing.

FXTM chief market strategist Hussein Sayed believes the selloff seen last Wednesday and Thursday is more than just the fault of the US Fed, pointing out that the US-China trade war as well as renewed sanctions on Iran also contributed to market jitters.

“His (Trump) actions helped build inflationary pressures and the Fed cannot stand still when it sees the economy overheating. A steeper selloff in equity markets will probably lead to a pause in hiking rates, but the Fed will be more concerned about the overall economic performance than just equity prices,” Hussein says.

He believes the earnings season for US corporates, which began last Friday, will be a key determinant of whether the stock market can continue its upward trend.

“Now it is up to the earnings season, which kicks off on Friday to convince investors that earnings are still robust and the outlook is rosy. If Corporate America paints a gloomy picture due to trade disputes, higher import prices, a stronger dollar and other variables, this will confirm that stocks have topped out for 2018,” says Hussein.

The saying that when the US sneezes, the world catches a cold, is still true. This was amply demonstrated last week as the rest of the world followed Wall Street’s worst week since March. Euro Stoxx 50, Europe’s leading blue-chip index for the eurozone, fell 4.07% to 3,209.19 points.

Japan’s Nikkei 225 fell 4.6% throughout last week (until Friday) to close at 22,694.66 points. China’s Shanghai Stock Exchange Composite declined 7.6% to 2,606.91 points while Hong Kong’s Hang Seng Index dropped 2.9% to 25,801.49. The last time regional stock markets saw a worse week was in February.

The MSCI AC Asia ex-Japan Index also fell 5.7% last week, to its lowest level in 18 months at 585.8 points. At home, the FBM KLCI had its worst week since June this year as it closed 2.6% lower at 1730.74 points.

DBS Bank Ltd’s regional equity strategist Joanne Goh agrees that episodes of market crashes in October have scared investors and made them jittery during this period.

“Asian markets have declined significantly since early October, with the Asia benchmark down 10.6% in US dollar terms,” Goh says in an Oct 12 note.

However, she says Asian economies are resilient in turbulent times with flexible policy options to cushion a slowdown, adding that long-term economic plans are in place to focus on stability and sustainability, especially in China and Singapore.


Valuation a concern for US stocks?

The valuation of US stocks is another area that fund managers are concerned about. One of them is Datuk Seri Cheah Cheng Hye, founding chairman and co-chief investment officer of Hong Kong-listed Value Partners Group Ltd. He tells The Edge that he believes the US stock market is way overvalued at the current levels.

“The S&P is trading at 40% above its long-term average. The US market is waiting for a fall. The business cycle in America is reaching a high. After the high, things will have to drop as there is a potential recession. Interest rates have to go up. There have been artificial reasons why the US market has been so strong, partly due to a huge surge in share buyback activities by American companies,” says Cheah.

His opinion was shared by most market observers. Most fund managers are wary of betting against the US stock market too early, but many are finding more enticing opportunities outside America. This is mainly due to the divergence in stock market performance. While US stocks have continued to maintain an upward trend, hitting record highs prior to the correction over last week, the rest of the world is struggling to maintain gains.

For perspective, the US market has still seen a strong performance with the Dow and S&P 500 recording  total returns of 3.1% and 3.6% respectively year to date. The tech-heavy Nasdaq Composite has seen a total return of 7.1% so far this year. In comparison, the MSCI AC Asia ex-Japan saw a decline of 16.1% YTD while China’s equity benchmark, the Shanghai Stock Exchange Composite Index, has fallen by about 20% so far this year.

Huang Juin Hao, senior portfolio manager at Affin Hwang Asset Management, however, does not think US stock markets are too expensive, pointing out that the valuations of US equities are broadly close to average, with the Dow and S&P 500 trading at 15 times and 14 times forward price earnings (PE) respectively.

Huang, however, believes that the outlook for the market is uncertain and would need to get past the US mid-term elections to have more clarity.

As for the Chinese market, despite the Shanghai Stock Exchange Composite Index seeing a decline of about 20% YTD, Cheah believes the outlook for China in the medium term is quite optimistic, pointing out that the economy is still growing at a respectable rate despite trade war concerns. He believes the country is still on track to become the world’s largest economy in about 10 years’ time.

“China’s economy is not driven by trade as many people think, it is driven by domestic demand and infrastructure investment. Net export is only a small part of Chinese economic growth. The trade war is very unpleasant and painful for China, but it is not a disaster.

“Remember, the market is not about today’s reality, it is a discounting mechanism to look at the future. The market rises and falls in response to people’s expectations about the future, not about today. Today, the situation in China is not good because of the trade war and economic slowdown. But what about a year from now? Or even two to three years from now? We have to be thinking. My view is that in the next one to three years, the Chinese market will be higher than it is today,” he says.

According to Cheah, Chinese stocks are also trading well below average, with a PE ratio of about 11 times, and the MSCI and other foreign index players are only beginning to increase China’s weightings. He notes that foreign ownership of Chinese stocks remains very low at 3%, compared with 25% to 30% in other Asian countries, indicating potential for an increase in foreign buyers.

Huang agrees that Chinese stocks are trading below average but he does not think it is a significant discount.

“The index (MSCI China Index) has derated to just above nine times forward PE, which is below mean but not excessively cheap,” he says.

As for emerging markets, Huang says the valuation of the MSCI EM Index is attractive as it is trading at below 10 times forward PE, approaching two standard deviations below mean. However, he cautions that there may be further downgrades of forward earnings estimates once the full impact of the trade war becomes apparent next year. This could raise the PE valuation going forward and bring it closer to the long-term mean.

DBS’ Goh, on the other hand, believes that the high cash level among Asia ex-Japan funds suggests that there will be more bullets for the markets to stage a rebound once some of the uncertainties are resolved.


Rising uncertainty as US-China trade war escalates

Huang believes investors are likely to seek shelter from the rising uncertainty due to the US-China trade tensions by raising cash levels and positioning themselves towards domestic sectors with defensive sustainable high yields.

“We believe the markets will react more towards the rise of uncertainty over the cost increases driven by US-China trade tariffs and possible elasticity impacts on end-consumer demand rather than any supply chain relocation as any supply chain relocation process will take time to occur,” he says.

He adds that the likelihood of trade tensions escalating has been rising given the increasingly harder statements and posturing by both countries as well as military activities in the South China Sea.

“Actions from both sides have become increasingly antagonistic and the allegations of spy-chip insertions into the supply chain of US tech companies and the US arrest of a Chinese senior intelligence officer will certainly add fuel to the already heightened tensions between the US and China.

“This raises the risk of a geopolitical incident occurring and spiralling out of control, and while we hope that tensions can be prevented from escalating further, there is no denying that the risk level in the markets has increased,” he says.

Cheah, however, believes that a full-blown trade war between the US and China is unlikely. “I know people are scared of a trade war. But I actually doubt the US will go for a full-blown war … Now I see signs that the US is taking measures against China, but they will not go all the way because it is beginning to hurt American consumers too, in the form of higher prices for consumer goods. The Chinese government has ample room to manoeuvre — the reserve requirement ratio (RRR) cut was only one of many measures they can take.”

DBS economist Nathan Chow writes in a weekly note on economics and strategy on Oct 12 that China’s policymakers have shifted from deleveraging to supporting the economy.

“On Oct 7, the PBOC (People’s Bank of China) announced a cut to the RRR, effective on Oct 15. This is the fourth reduction this year and will take the ratio for large banks to 14.5%. The cut and timing are in line with our expectations. This is intended to strengthen support for growth, as the recent policy support plus tax cuts and increased infrastructure funding have yet to show signs of turning the economy around,” he says.

Similar to Chow, Duncan Tan, strategist at DBS, and Taimur Baig, chief economist at DBS, say in the same report that the ongoing market selloff hardly represents a healthy cleaning out of positions.

“For value to emerge, many uncertainties need to be resolved (oil, US-China trade war, US dollar liquidity, interest rates), something we don’t envision anytime soon,” they write.

As far as the relationship between the US and China is concerned, a potential meeting between Trump and Chinese President Xi Jinping next month at the G20 summit in Buenos Aires may spark hopes for a resolution on the trade conflict between the two countries.

But with the Fed set on raising rates, markets could be in for more volatility ahead.

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