After witnessing a good deal of momentum which continued into early 2018, investors experienced a tough ride for the remaining first half of the year. Last month in particular, we saw how the change in tones of words between Beijing and Washington officials quickly escalated into ripples across global equities. Against a backdrop of rising interest rates in the US and equities hitting fresh lows, its hard for investors to not think that this may be the beginning of the bear market. In this article, we look to share our view with investors on why we think the markets are not headed for a bear territory at this juncture.
Rising risk free rates: Fed is doing it predictably
At the beginning of the year we have noted that inflation is one area to look out for and would like to reiterate our view on this matter again. While we understand that US Fed has embarked on a gradual path in the current rate hike cycle as to preserve US economy’s growth momentum, another key reason that was “holding back” the Fed officials from a fast-paced rate hike would be the benign inflation.
FIGURE 1: Inflation is gradually ticking higher.
Over 1H2018, inflation has started trending higher on the US’s economic front (see Figure 1), which suggests that US consumer spending may have finally gained traction. While there are now increased possibilities of a faster pace of rate hikes, we think investors can draw comfort from the Fed’s transparent and forward-guiding communication stance. Hence, we think monetary decisions from the US front are unlikely to induce volatilities on global equities.
Also, given that the Fed rates are now sitting comfortably above zero, the Fed now has more monetary flexibility to deal with any unexpected stunts towards economic growth.
US against the world: no full-blown trade war
Global equities have posted hefty declines last month, with most of the markets under our coverage ended in red. The White House has launched a trade war on three fronts, namely China, Canada and Mexico, and the European Union. Needless to say, the trade policy conflicts are a major source of uncertainty for the economy and financial markets and have dominated recent market movements.
FIGURE 2: Trade expectations are still holding up despite escalation of trade tensions
At this juncture, we have yet to see the materialised impact from increased tariffs, as trade figures across the globe are still showing healthy signs of global aggregate demand. Leading indicators such as the Morgan Stanley Global Trade Index (see Figure 2) are also holding up well. Although many have forecasted increased tariffs are likely to have a limited impact on GDP growth, an escalation of tensions between major economies is likely to lead to more significant market disruptions in the months ahead.
That said, the current decline across the board is not tied to any material change in the fundamentals of the economy or significant downward revision in earnings estimates. That leaves us with an opportunity to look into regions and countries that offers decent growth potential.
Jittery investors: it’s a good thing
The remarkable rally in financial markets last year was built on the recovery of global economy as well as record profits posted by companies. Although some contrarians have voiced their concerns for overheating market and higher valuations, we noted that market participants are now more cautious and wary of the developments on the economic front (see Figure 3), thanks to the on-going trade spat which jolted equity markets. This reduces the possibility of a meltdown of asset prices.
FIGURE 3: Investors are more cautious now compared to 2017.
FIGURE 4: Valuations are not showing signs of exuberance yet.
For those who are not new to the market, many of the previous crashes were led by the irrational exuberance, which gave rise to a bubble in asset prices. Projecting recent memories, the tech crash in 2000 and housing bubble in 2007 were built on euphoric sentiment rather than improvement in asset fundamentals. Eventually, the subsequent sell-off led to severe losses.
Most of the current concerns are stemming from policy wrongfooting, particularly on the global trade front. Our base case is that there will not be a full-blown trade war, doing so would choke off precious growth momentum and aggregate demand that various policymakers have been struggling to revive over the past few years. For the worst, should the implementations of policy yielded undesired outcome,
those policies could be reversed. This spares policymakers with some room for rectification.
Looking at pre-crisis valuations in the past, we have yet to see asset prices derailing from their respective fundamentals. We think this area is an important one to look out for because unlike policies, steep drop in asset prices and loss in portfolio values are irreversible. With the above said, we think markets are not headed for a bear territory yet.
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