Both Asian and global investors are increasingly concerned that this is the start of a larger market correction. The U.S. and European equity markets have reversed their year-start gains and ended January lower. In this issue of On the Minds of Investors, we discuss the reasons for the anxiety, our medium to long-term view on asset allocation and what investors should do.
Let’s start with the “why?” Valuations have started the year at an elevated level. Forward price-to-earnings for U.S. and a number of markets around the world have been trading at the top of their 10-15 year range. Credit spreads, whether for investment grade or high yield, are approaching their pre-pandemic lows. These are fueling investors’ concerns that markets are getting overheated. The extreme swing in selected stocks due to retail investors’ participation, resulting in a short squeeze of some hedge fund positions, added to this worry.
Meanwhile, the excitement of vaccine development is replaced by the reality of production, distribution logistics and questions on effectiveness. The U.S. and the UK are making steady progress in inoculating their population. However, there is some confusion in the availability of vaccines and distribution in Europe and that is worrying investors about the prospects of economic recovery.
Several Asian central banks have also expressed concerns over asset inflation, such as South Korea and New Zealand. In particular, the People’s Bank of China has warned of the risk of asset bubbles in real estates and equities and suggested the importance of supporting the real economy. This was accompanied by money market operations to drain liquidity out of the system, which was unusual since it typically did the opposite ahead of the Lunar New Year holiday. Investors are also worried that governments would be less willing, or able, to support the economy via fiscal policies. Republican senators are offering a counter proposal of USD 600billion against U.S. President Joe Biden’s USD 1.9trillion fiscal package. It is not immediately clear how European governments would react to a delayed recovery if progress on vaccination comes behind schedule.
What is our latest view? We maintain our constructive view on equities while acknowledging the near-term risk of more volatility. Despite the bumps in distribution, early data from Israel has shown that those who are vaccinated have a reduced rate of inflection. Hence, our view of a second-half recovery supported by improvement from the pandemic is still intact. The pace of recovery could vary by region, but the outlook of the U.S. and China, the world’s two largest economies, is positive.
EXHIBIT 1: GLOBAL EQUITIES: VALUATIONS
Despite warnings from Asian central banks on asset inflation, the Bank of Japan, European Central Bank and the U.S. Federal Reserve are still fully committed to maintaining zero policy rates for the foreseeable future, while maintaining asset purchases until their economies show sufficient improvement. We think any discussion of tapering in the U.S. may need to wait until late 2021. Europe and Japan would be later still. This implies that the ample liquidity environment could continue for some time. For Asian central banks, they may not opt to raise interest rates for now, but instead re-introduce some macro-prudential market measures to cool asset markets, especially in real estate. They do not want property inflation to undermine affordability, which would lead to social issues.
Higher levels of market volatility requires investors to be disciplined in two ways. First, investors will need to rebalance their portfolios according to their financial objectives. Assuming investors had the correct equity / bond allocation ahead of the equity rally since October, the outperformance in equity would require investors to reduce equity/add bonds so the portfolio returns to the appropriate allocation. It should be noted that the fixed income allocation here should be broadened to corporate credits and emerging market debt (EMD). The limited movement in developed market government bonds, especially U.S. Treasuries, in the face of falling equities illustrate their diminished role in providing protection against market corrections. While corporate credits and EMD have a positive correlation with equities, their income component provides a consistent cash flow during moments of volatility, even if their nominal bond price can also swing with market condition.
The second discipline is diversification. While selected markets and sectors are expensive relative to forward earnings and book value, not all markets are in the same position. We have advocated investors to be more diversified this year, both by region and by sector, given our expectation of a more comprehensive recovery from COVID-19. On top of keeping the U.S., China and technology as long-term structural allocation, investors should take a closer look at ASEAN, Europe and emerging markets ex-Asia. For investors who have under-allocated into equities, any upcoming correction could be an interesting opportunity to add.