Outlook: Look for the sweet spots, says OCBC

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on February 18, 2019 - February 24, 2019.
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While multiple events last year have created fears of an imminent recession, investors should not be spooked. Instead, they should consider investing in some sweet spots that have since emerged in the market, according to OCBC Singapore vice-president and senior investment strategist Vasu Menon.

“There is no reason for investors to be too negative towards the stock market this year simply because 2018 was a down year. A lot of the concerns have been priced in. There is no doubt that the negativity will still be here. They are all live events after all. But historically speaking, a down year is usually followed by an up year,” he says.

One of those sweet spots can be found in Asia ex-Japan, which took a beating last year. “Asia had a bad year in 2018. The trade tensions between the US and China has dampened the latter’s growth, which in turn badly affected the Asian markets. Apart from being impacted by a strengthening US dollar, Asian markets also suffered from spillover effects of the crisis in emerging markets such as Turkey and Argentina,” says Menon.

“We saw sell-offs in Indonesia, India, the Philippines and many other markets. People are starting to worry about another Asian financial crisis, so currencies in the region also saw a sell-off last year.”

This year, things are looking up for Asia ex-Japan. Valuations are currently very attractive and any positive news on the US-China trade talks will be good for the region. Asia will also benefit if the US Federal Reserve meets market expectations by slowing down the pace of its interest rate hikes this year.

“When that happens, the US dollar may stop strengthening, or even weaken. The US currency typically has a pattern — six years of rally and six years of decline. We had six years of rally up to the end of last year, so it will likely take a breather. Given what is happening in the global economy, we may see a weaker US dollar and stronger Asian currencies, which is positive for Asia,” says Menon.

Within the region, he favours defensive sectors such as healthcare and consumer staples. Healthcare is attractive regardless of what stage the economic cycle is at due to the ageing population while consumer staples is recession-proof, he says. “We also like the financial sector because it has been beaten down and valuations are looking interesting at the moment.”

Investors may want to be cautious about sectors such as property and technology, says Menon. In Asia, the property sector has seen a lot of run-up in prices over the past few years and governments — especially in Singapore — have been trying to curb prices. That said, investors should not avoid real estate investment trusts (REITs).

In the fixed-income space, investors should consider increasing their allocation to high-yield bonds, which also saw a sell-off last year, says Menon. Both emerging and developed market high-yield bonds are starting to look attractive from a valuation perspective, he adds.

“We see selective opportunities in the high-yield bond space. The Fed is not going to hike rates in a big way going forward and that is good news for bond markets. Similarly, these markets will benefit if the global economy slows down as bonds are more defensive than stocks,” says Menon.

He believes that alternative assets such as gold do have a role to play in investors’ portfolios, but the yellow metal seems lacklustre at the moment. He sees it hovering between US$1,175 and US$1,280 per oz this year. He also believes that investors should put money in gold this year if there is a big pullback.

“The key thing for investors to do at this juncture is to diversify, not only across asset classes but also time. They should not put fresh money in the market for only one term, they ought to do it in phases. Spread it over the next 12 to 18 months by dollar-cost averaging because the market is going to be volatile,” says Menon.

“There will be periods when the market sees drawdowns because of overreactions and mispricing. These will create opportunities because there will be rebounds. Keep some dry powder that can be applied to a pullback.”

The typical characteristics of a late economic cycle are high volatility and a higher degree of perceived risk. In this environment, investors will be quick to take profit, says Menon. Because of that, the returns this year will not be as great as 2017 and the few preceding years.

“I think single-digit returns will be good enough. But again, you cannot be too negative towards the market simply because of what happened last year and assume that 2019 will be another bad year. This year, I think we will face a Goldilocks scenario — not too hot and not too cold. Thus, you will still be able to make money. You just have to invest more carefully, diversify, be patient and wait for the returns to come in,” he says.

Last year, the major stock markets saw big sell-offs due to four main contributors — trade tensions between the US and China, the sharp increase in interest rates by the Fed, the crisis in emerging markets and the decline in oil prices. These, on top of concerns about the underperforming US bond market, have caused investors to worry about an impending recession.

“These concerns were exacerbated by the fact that we are now at a very late stage of the economic cycle. People felt that after 10 years of expansion, a recession will take place. So these things have started playing on people’s minds, creating a big knock-on effect on the market,” says Menon.

 

Market drivers in 2019

According to Menon, there are four market drivers this year. First is the ongoing trade talks between the US and China, where any resolution or positive outcomes will be good for the market and vice versa.

“From US President Donald Trump’s side, we see both positives and negatives. Trump, his economic adviser Larry Kudlow and Secretary of the Treasury Steven Mnuchin all sound positive. But Secretary of Commerce Wilbur Ross does not sound so positive — he said they were miles away from a deal. Similarly, Trade Representative Robert Lighthizer does not sound positive,” says Menon.

The US and China want to reach a trade deal by March 1. However, Menon does not think there will be a complete and full resolution. While some issues may be resolved, the more serious ones — such as forced technology transfer from US corporates to Chinese companies — will not.

“These are sensitive issues, which I do not think they will touch. I also think the trade war is really an excuse for the US to contain China’s [influence] because if it does not, China may overtake the US as it now has strong economic, political and military power. That is why I do not see the containment exercise being completed in such a short period,” he says.

 Menon thinks Trump will want a positive outcome. The US president is someone who pays very close attention to the stock market, he adds. The sell-off in the US stock market last year made him realise that the trade war was impacting stock markets and the US economy. Between September and December last year, the S&P 500 fell 19.8%, almost slipping into bear market territory.

“I think that scared him a little. Because of that, I think he would want to see some positive outcomes from the trade talks. To him, his report card is the US stock market, and he took credit for the rally. That is why he is putting a lot of pressure on the Fed not to hike rates and on Saudi Arabia to bring down oil prices,” says Menon.

“These are why I think we will see some positive outcomes from the US-China trade talks, although some issues may not be resolved. It is also possible that Trump does not want to resolve all the issues because he clearly wants to use them for his presidential campaign in 2020. He wants people to know that he had got China to give him some concessions. He needs to complete his tasks so that the people will re-elect him.”

The market will gain more clarity by March 1, but the incident with Huawei is making it more complicated, says Menon. On Jan 28, the US Department of Justice indicted the Chinese company for theft of trade secrets, wire fraud and obstruction of justice. As China is not happy about this development, there is a chance that it will derail trade talks.

The second thing that the market is watching very carefully is what the Fed and other major central banks will do with interest rates, says Menon. “If we look at financial conditions globally, we will realise that things have become so tight to the point of dragging growth down. I think the central banks have come to recognise that they may have gone a bit too far. So, many have started to take their foot off the pedal, helping the stock markets to rebound.”

This year, the Fed will hold a press conference after every meeting. According to a statement by chairman Jerome Powell, that means all meetings are now “live” for possible interest rate increases. So, the US central bank may raise rates at any of its eight regular policy meetings, and not just the four for which it had been holding press conferences.

Menon thinks this can be both good and bad because the markets will latch on to every word that Powell says. “Some will be dovish and some will be hawkish. That will create some volatility. But I think the Fed does not have a case right now to do anything too drastic,” he says.

“The debate in the market is currently whether the Fed will stop quantitative tightening this year because of the slowdown in global economic growth. If this happens, it will be music to the ears of investors as it will be good for the stock and bond markets. Again, we need more clarity, although it is looking positive so far.”

The market is also paying close attention to the global economic growth numbers. So far, China’s economic data have been weak while the data coming out of Europe have been weaker than expected. Although the same level of weakness has not been seen in the US, the sentiment is beginning to be felt.

Nevertheless, Menon says slower economic data is to be expected this year. “After 10 years of economic expansion, no market or economy can continue to sprint. It has to take a breather. So, it is a question of whether it is a breather or a heart attack. People will watch the growth numbers and they will continue watching for the rest of the year.”

The final driver of the market will be political risk in Europe. The UK is scheduled to leave the EU on March 29. Despite this, the markets still do not have a clear view of whether this will truly happen. If the UK exits with no deal, it will create a recession in the country. Menon says this will be very negative on Europe and perhaps even the rest of the world.

“Everyone now recognises that the problem is very serious and cannot be resolved anytime soon. So, there may be an extension or even a call for a second referendum. Eventually, it is possible that we may not even see a Brexit,” he adds.

“As far as the EU is concerned, that will be good news for them. They are trying to keep the union together — having one party leave the club may motivate others to do so as well. Now, there is a public display to show the rest of the world that doing so can be very difficult. If there is no Brexit, there will be relief in the markets as there will be less political risk in Europe.”