While financial markets were rocked in the first quarter as volatility struck back with a vengeance, the second quarter was nonetheless turbulent as well. Equity markets as a whole climbed steadily in the earlier part of 2Q 18, but risk aversion came back as trade tensions haunted market participants once again. The MSCI AC World Index rose
4.3% in MYR terms in the second quarter, despite registering a year-to-date loss of -2.2%. Much of the positive gains in the headline index was supported by the US equity market, which was the most resilient among the developed markets in 2Q 18. On the other hand, bonds on aggregate were not spectacular either, posting a
-2.3% loss year-to-date (-1.5% in USD terms).
While the US was the strongest performer among the developed markets such as Europe and Japan, emerging markets as a whole underperformed the developed markets, with the MSCI Emerging Markets Index falling by -4.6% in 2Q 18 on a total return basis (-8.4% in 1H 18). Certain emerging markets with weaker credit and growth profiles were impacted more by the recent broad-based strength of the USD, while those who are more trade-reliant saw sharper losses particularly in late-June when news of the Trump Administration’s trade tariffs on Chinese imports into the US hit markets once again.
On the monetary policy front, the US Federal Reserve went ahead with its well-communicated second 25 basis point rate hike in its June meeting, bringing the Fed Funds rate to a range of 1.75% – 2.00%. Other than reaffirming that growth in the US is robust, the Fed committee also updated its dot plot projections, with the latest median forecast suggesting that there is a possibility of another two more hikes for the rest of the year. At the other end of the Atlantic, the European Central Bank (ECB) kept its benchmark policy rates unchanged, but announced that after September, it will reduce the current monthly pace of asset purchases to EUR 15 billion until the end of December and cease purchases after that, in effect ending its quantitative easing programme that was launched since 2015. The ECB added that it will maintain the current policy of reinvesting the principal payments from maturing securities that were purchases for its current stimulus programme, and that it intends to do so ‘for an extended period of time’ after the end of its asset purchases to maintain monetary accommodation. The ECB also lowered its projection for 2018’s GDP to be a 2.1% rate but kept its 2019 forecast unchanged at 1.9%, and revised headline inflation projections for both 2018 and 2019.
In emerging markets, countries such as Turkey, Argentina and Indonesia saw their respective local equity markets and currencies impacted following a broad-based rebound in the USD. Unlike the ‘Taper Tantrum’ episode back in the summer of 2013, the reactions in various emerging markets across the world were varied; markets with weaker credit profiles (such as higher current account deficits) or those who rely more on foreign USD financing were more adversely impacted as capital outflows occurred. We do not think that this will be a second ‘Tantrum’ as fundamentals across various emerging markets are different and for some cases, stronger, than what we saw in 2013. Across Asian markets, valuations are now more attractive than before, and with regards to trade tensions, we believe that events are fluid and as such, investors should not make knee-jerk reactions to some of these developments. Moreover, investors should also note that not every economy would be affected adversely if trade tensions escalate and a full-blown trade war materialises.
Market Performance (in MYR terms).
||MSCI AC World
||MSCI Asia ex-Japan
||MSCI Emerging Markets
||CSI 300 Index
Bloomberg, iFAST compilations. Returns in MYR terms, excluding dividends, as
of end-June 2018.
As we head into 2H 2018, we take a closer look at some of the top-performing markets for the first half of the year (US, Russia, Japan) as well as those at the bottom (Indonesia, China A, Brazil) to identify some of the key reasons for their performance as well as our outlook for each market.
[All returns in MYR terms unless otherwise stated as of 29 June 2018]
US (+0.9% in 1H 18 in MYR terms)
US equities on aggregate were more resilient as compared to other developed and emerging markets under our coverage in 2Q 18, with the S&P 500 Index gaining 7.2%, making year-to-date performance a
0.9% gain (1.7% in local currency terms). Some of the best performing stocks in the first half include Netflix, TripAdvisor, Macy’s and Advanced Micro Devices, while Nektar Therapeutics, Arconic Inc, Signet Jewelers and Goodyear Tire are some of the bottom performers.
Over the second quarter, corporate earnings estimates of American companies have been revised higher, with 2018’s and 2019’s estimates raised 2.1% and 1.7% respectively. The energy sector alone saw its earnings estimates for 2018 upgraded 15.4% as crude oil prices rose, while the materials sector also saw an upgrade to overall EPS. US healthcare-related companies saw slight upgrades to aggregate earnings estimates, while the information technology (IT) sector once again enjoyed earnings upgrades, continuing the trend of upgrades in previous quarters as earnings prospects remain bright. Year-to-date, sell-side analysts have projected increases to earnings of US corporations as they enjoy tax savings from the recent change in the fiscal code by the Trump Administration. Thus far, earnings upgrades have been strongest in the cyclicals sectors such as the financials, industrials, materials, energy and the IT sectors.
The labour market is particularly robust as employment data is healthy and the latest data for wages revealed moderate increases. This current trend supports the outlook for domestic consumption in the US for 2H 18. With regards to leading indicators, the ISM’s headline PMIs registered increases in May from April, with new orders, employment and backlogs all recording increases (the new export orders components fell in May). While overall business sentiment remains healthy, it remains to be seen if the fallout from the latest tariffs and uncertainty surrounding trade-policy could adversely affect the current momentum in the US.
The Federal Reserve went ahead with its well-televised 25 basis point rate hike in its June meeting, bringing the Fed Funds rate up to a range of 1.75% – 2.00%. Other than reaffirming that the US economy is robust, the Fed also updated its dot plot projections, with the latest median forecast suggesting that there is a possibility of another two more 25-basis point rate hikes for the rest of 2018.
At current levels, US equities trade at estimated PE ratios of 17.1X and 15.5X for 2018 and 2019 respectively, as compared to its fair PE ratio of 15.0X. We acknowledge the near-term benefits of the recent fiscal package (supporting investment and spending), but are cognisant of still-stretched valuations that limit the potential upside to any long term investor.
Thus we maintain our rating of 2.0 Stars “Unattractive” for the US equity market.
Russia (-0.8% in 1H 18 in MYR terms)
Amidst the risk aversion in markets, the Russian equity market was one of the more resilient ones under our coverage this time round, incurring a -3.5% loss in 2Q 18 to make its overall performance in the first half of 2018 a
-0.8% loss (0.0% in local currency terms). Energy-related companies such as Rosneft, Lukoil and Novatek saw their stock prices clock a positive gain in the first half of the year, helping to boost the index’s overall performance. Yandex and steel players such as Novolipetsk and Severstal also were among the top performing stocks. On the other hand, Mechel, Sistema, United Wagon and PhosAgro were some of the bottom performers in 1H 18.
Corporate earnings revisions have generally been on an uptrend over the first half, partially driven by the Rouble’s (RUB) broad-based depreciation particularly after the Trump Administration’s new round of targeted sanctions against Russia in April. Companies that derive a substantial portion of their revenue in foreign hard currencies (like the USD) while incurring RUB-denominated expenses tend to enjoy earnings translation benefits when the RUB stays weak. In 2Q 18, Russian companies saw earnings estimates for 2018 revised 9.7% and 2019’s estimates upgraded 8.5% higher. Thus, total upgrades for 2018 and 2019 respectively were 15.1% and 13.6% respectively. The heavily-weighted energy sector enjoyed the bulk of earnings upgrades as sell-side analyst price in the benefits of higher crude oil prices. On the other hand, the banks such as Sberbank, which has seen continued earnings upgrades from 2017 into this year, saw no changes to its 2018’s EPS for the entire second quarter.
In terms of economic data, hard data continues to suggest improving fundamentals in Russia. Real retail sales has continued to post healthy numbers on the back of improving household consumption, and industrial production maintaining its overall uptrend; clocking in a 3.7% year-on-year rate as compared to an upward-revised 3.9% year-on-year gain in April. The domestic economy continues to improve despite the geopolitical tensions between the West and Russia. Leading indicators such as the Markit PMI series for Russia softened in May from April, with the headline number weighed down by manufacturing. Despite some cooling in sentiment readings, we do not expect an outright contraction in growth over the next two and three quarters. It also remains to be seen if the recent weakening of the RUB and any consequent adverse effects of it could negatively impact the recovery in consumption in the country.
The RTSI$ Index trades at 5.9X and 5.8X 2018’s and 2019’s estimated earnings respectively, as compared to its fair PE ratio of 7.0X. Sentiment has been damaged given the recent capital outflows from emerging markets as a whole, but fundamentals of the market remain stronger than four years ago during following the Crimea situation and the worldwide crash in oil prices. Geopolitical risks remain for the Russian market, thus, direct exposure is only suitable for aggressive investors willing to stomach higher levels of volatility.
We retain a star rating of 3.5 Stars “Attractive” for Russia.
Japan (-1.2% in 1H 18 in MYR terms)
As of 29 June, Nikkei 225 index which represents the Japanese
equity market fell -1.2% year-to-date (-2.0% in local currency terms), with 2Q’s return being
4.1%. Movements of US interest rates and Sino-US trade tensions have dominated investors’ focus within the second quarter. The quarter ended with investors concerned over the risks of escalation in trade tensions between the US and her major trading partners, which has affected the performance of Japanese equities. We have noticed that the USDJPY exchange rate has moved in line with the trend of US Treasury yields over the period.
Corporate earnings estimates of Japanese companies on aggregate saw changes since the start of the new financial year, with 2018’s earnings being revised -0.5% lower while 2019’s earnings estimates were raised 0.9% higher over the past three months. Railway company Showa Denko, Shin-Etsu Chemical, Tokio Marine Holdings and Kao Corp saw EPS estimates raised year-to-date, while Mitsubishi UFJ Financial, Chiba Bank, and railway companies saw earnings downgrades thus far.
In terms of economic data, with machinery and electric machinery exports growth bouncing back to higher levels in April and May, and retailers benefiting from higher domestic household demand given a robust labour market, we might see stronger than expected earnings in upcoming quarters, especially when companies are still issuing conservative earnings guidelines and sell-side analysts follow suit. A potential upbeat in earnings, coupled with the currently-attractive valuation profile of the Japanese market, could lift Japanese equities to climb higher over the medium-to-long term.
Besides earnings being in-line with our expectations, the risk of Prime Minister Shinzo Abe failing to reach his third term is now lower with surveys showing that the public approval rate for Abe rebounded in June and his support rate among Liberal Democratic Party (LDP) voters remain in a dominant position as compared to potential competitors. The LDP’s leadership vote will take place in September, and we are expecting Abe to win another term and ensure continuity in accommodative economic measures, which should support corporate earnings growth as a whole.
Continued trade tensions between the US and her trading partners may consistently bug Japanese equities, alongside other markets, until tensions dissipate. Market sentiment is weighed down by this development and volatility could well remain in the quarter ahead into the US mid-term elections. As of end-June 2018, the Nikkei Index trades at 16.1X and 13.9X FY 2018’s and FY 2019’s estimated earnings, as compared to its fair PE ratio of 18.5X.
We maintain a 3.5 Stars “Attractive” rating for the Japanese equity market.
Indonesia (-13.8% in 1H 18 in MYR terms)
Indonesian equities, represented by the JCI index, fell -13.8% over 1H 18 to end the first half of this year as one of the bottom three performing markets under our coverage. In local currency terms, the market incurred a -8.8% loss. 1H 18 was a turbulent period for the Indonesian equity market. Concerns of a possible full-blown trade war as well as rate hikes have weighed on investor sentiment. The selloff was exacerbated when foreign investors pulled their investments from Indonesia in the wake of USD strength.
Regarding economic data, Bank Indonesia’s (BI) Consumer Survey showed that Indonesian consumers were more optimistic on current economic dynamics in May 2018 compared with the previous period. The Consumer Confidence Index went up to 125.1 in May from 122.2 in the previous month. This was the highest reading in four months, mainly driven by an improvement in the gauge of current economic conditions, rising current incomes coupled with consumer perception of improving conditions for buying durable goods as a result of annual Eid-al-Fitr bonuses and the corresponding Eid-al-Fitr celebrations. As such, this would be a great boost for Indonesia’s overall economic growth as private consumption accounts for about 57% of the nation’s total economic growth.
Earnings forecast for the JCI index was revised upwards by 5.2% and 4.1% for 2018 and 2019 respectively as of 29 June 2018. Most of the upgrades are attributable to the Energy and Materials sector, where the latter is expected to benefit from the revival of nickel production in Indonesia after the government relaxed its nickel ore export ban. Analysts opined that the trade war threat poses little risk to global nickel market, considering that China’s stainless-steel exports to the US only made up 1.2% of China’s total stainless-steel exports in 1Q 18. Meanwhile, the consumer staple sector had its earnings estimates revised downwards by analysts over the months as the industry players’ profit margin were negatively impacted by rising advertising and promotional expenses in order to capture higher market share.
As for Indonesia, the economic outlook continues to be positive with GDP growth projected to rise at a steady pace moving forward. We believe the imminent local elections in mid-2018 as well as the 2018 Asian Games will give additional boost to the local economy moving forward. In light of strong domestic demand, contribution from net exports is expected to be muted as import growth strengthens. From a valuation standpoint, the JCI index is trading at PE ratios of 14.7X and 13.2X based on estimated earnings for 2018 and 2019 respectively, below its estimated fair PE ratio of 16.0X (as of 29 June 2018). In consideration of the solid fundamentals, upgraded earnings estimates and attractive valuation in Indonesia,
we have upgraded its star rating from a prior of 3.0 Stars “Attractive” to 3.5 starts “Attractive” in the middle of June to reflect this view.
China A (-15.1% in 1H 18 in MYR terms)
The China A equity market, as represented by CSI 300 index, fell -15.1% in 1H 18 (-12.9% in local currency terms), consequently landing itself as one of the bottom performers under our coverage. By the end of June, among 10 sectors under CSI 300 index, healthcare sector is the only one posting a positive return of 16.86%; the rest of sectors delivered negative returns, the worst of which is telecom sector with -37.56% decline. Furthermore, investors’ risk appetite were affected as trade tensions between China and the US rose.
Generally speaking, the onshore equity market has gone through two notable downward adjustments this year, with -6.36% decline in February and -8.01% decline in June. Back in February, thanks to tax cuts and increased consumer spending, US policy-makers saw increased economic growth beating market consensus, and communicated their confidence, which worried the market that the pace of rate hikes may accelerate, resulting in the market’s adjustment. The latest adjustment happened after Dragon boat festival, when US announced on the 15th June that it would impose 25% import tax on USD 50 billion of Chinese products in July. As a result, China A has gone through a period of higher volatility and a rapid sell-off; the Shenzhen indexes have declined around 7.0% within two weeks, and the trend continued throughout late-June.
However, recent released economic data like industrial production as well as retail sales data have been on an uptrend, which suggests solid fundamentals. China's economy grew 6.8% in 1Q 18, which topped a consensus estimate of 6.7% year-over-year growth for the quarter. We believe that the GDP growth may face downside pressure but still will achieve the 2018 government’s 6.5% target, and this will enable China to achieve relatively full employment. Besides, the Caixin China General Manufacturing PMI stood at 51.1 in May 2018, the same as in April but below market consensus of 51.3, which still remained above the key line of 50 that separates expansion from contraction. Another catalyst for upward re-rating is the inclusion of A-shares in the MSCI indices. The move could trigger an inflow of around USD 9 billion and more than USD 200 billion into the onshore markets over the next five years, which will support the A-share market valuation going forward.
From a valuation perspective, we believe that the A share is at the bottom range. Many data have shown that the downside risk is limited for the moment. For example, by the end of June, according to Wind database, there are 227 shares with lower than a PB ratio that is lower than 1.0X, more than what we saw in 2016. Besides, the trading volume between RMB 300 and 400 billion has lasted for quite long, lower than historical average, so is the credit trade volume.
While Chinese A-shares underperformed global equities in the first half year, its underperformance translates into valuations that continue to be attractive to invest in 2018. As at 29 June 2018, the CSI 300 Index is currently trading at estimated PE ratios of 10.5X and 9.2X based on estimated earnings in 2018 and 2019 respectively, a discount to its fair value of 15.0X.
As such we maintain our 3.5 Stars "Attractive" rating for the China A-share market.
Brazil (-19.2% in 1H 18 in MYR terms)
After being one of the most resilient markets under our coverage in 1Q 18, the tables were turned on Brazil in the second quarter as a rout transpired across Latin American markets. Brazilian equities, represented by the Bovespa Index, plunged -24.1% (-14.8% in BRL terms) in 2Q 18, consequently recording a year-to-date loss of -19.2%. Magazine Luiza, Fibria Celulose, Vale and Klabin were some of the top performing stocks in the first half, while Kroton Educacional, Ultrapar Participacoes, CCR and Cielo could be found at the bottom of the performance table.
Over the second quarter, Brazilian corporations (as gauged by the Bovespa Index) saw their earnings estimates revised lower, with 2018’s and 2019’s estimates lowered -2.2% and -0.9% respectively (as of 29 June 2018). This makes year-to-date upgrades for 2018 and 2019 to be 8.3% and 5.4% respectively. Steel players such as Gerdau and energy titan Petroleo Brasileiro (Petrobras) were a few companies that enjoyed earnings upgrades. The banks (i.e. Itau Unibanco, Banco Bradesco), which are an index heavyweight, also saw less earnings upgrades in 2Q 18, but have seen earnings upgrades on a year-to-date basis. On the other hand, consumer-related companies such as beverage titan Ambev saw earnings estimate slashed over the quarter, alongside companies such as Lojas Renner, Lojas Americanas and BR Malls Participacoes.
In terms of economic data, hard data such as industrial production and retail sales have continued to record year-on-year percentage gains with upward revisions seen for data in March. Inflation, gauged by the CPI measures, rose slightly higher in May as compared to April. Additionally, leading indicators such as the manufacturing and services PMI eased in May as compared to the prior months. A cooling in overall momentum may be happening as a series of local events, including increasing political uncertainty, weigh on business and consumer confidence. This could result in the possibility of growth momentum slowing in 3Q 18 as businesses hold back on investment and households on spending if sentiment continues to sour. However, we are not expecting an outright recession in Brazil for 2018.
At current levels, Brazil’s equity market trades at 11.0X and 9.6X 2018’s and 2019’s estimated earnings respectively, as compared to its fair PE ratio of 11.5X.
We have raised Brazil’s star ratings to 3.0 Stars “Attractive” as explained in our update. Interested investors can consider adding exposure incrementally as overall market movements in the near-term could remain choppy as political developments weigh on investor sentiment.
A Return of Volatility Has Thrown Up Opportunities
The turbulent first half of the year has resulted in a reset in investor sentiment and lower valuations in many equity markets worldwide. Although concerns remain over rising trade tensions, we do not think that it would entirely damage growth prospects for the global economy.
We have pointed out earlier that a higher volatility regime is ahead of us, and it is in such a market environment that diligent active investors can thrive as Mr Market throws up opportunities. It is also in such a market environment that passively-managed index strategies may not be an optimal solution to navigate conditions moving forward.
Regarding fixed income, we have been right in being prudent and maintaining a defensive stance on bond markets as a whole, as yields are now higher than where they were in the start of the year. Valuations for certain segments such as emerging market debt have also improved as spreads widened in the second quarter, and at current levels, are starting to look interesting.